Relative Strength Index (RSI)
What is RSI?
RSI is an indicator that falls under the category of oscillators, and it is an extremely simple indicator to use. RSI works well in range-bound markets, but it has limited value in trending or breakout markets. RSI was created by Welles Wilder, who also created ATR, Parabolic SAR and other well-known indicators.
The Concept of Oscillators
Oscillators are chart studies that are designed to show the strength of the current price in relation to the recent price action. As such, they display the short term momentum of the market, giving signals that the bias of the market is shifting before the price actually changes directions.
The principle upon which oscillators are based is that of regression to a mean. Essentially, a large part of a statistical sample should be within a certain number of standard deviations from the mean of the sample, and if the price strays too far from this center, then it will likely revert back to the rest of the sample. In terms of trading, the price should not rise or fall too far in too short a time.
Oscillators are not usually displayed on the same graph as the price itself, but are most often placed at the bottom of the chart to show that the fluctuations do not occur on the same scale as the price movement.
What RSI Does
Like all oscillators, RSI offer indications of when a currency pair is overbought/oversold. RSI essentially calculates the strength of all upward candles (green) against the strength of all downward candles (red) over the course of the specified time frame.
Parameters
When pulling up RSI on a chart, the charting application will prompt you to select how many periods you would like to include in your study. The most commonly number used is 14, and most traders do not alter this default setting. Some traders do use 9 or 25 period RSI's instead of the standard 14. Of course, increasing the number of inputs will decrease the number of signals and increase the reliability of these signals. Decreasing the number of inputs would have the opposite effect.
How to Use RSI in Trading
- Can be used to determine overbought/oversold levels
- Used to spot divergences, which indicate potential weaknesses in trends
Overbought/Oversold
If RSI is above 70, the pair is considered to be overbought. Some traders enter short at this point, but this can be dangerous as the price may still be rising. Enter short when the RSI crosses back under 70, as this may indicate that the momentum has turned. If the RSI is below 30, the pair is considered to be oversold; enter when RSI crosses back above 30. Like most oscillators, RSI works best when the market is range-bound – in other words, when the market is expected to simply gravitate between an upper and lower level. In trending or momentum-driven markets, using the overbought/oversold levels offered by RSI is generally of limited value.
Divergence.
RSI can also be used to signal when a trend is weakening. If a currency pair makes new highs in its price but RSI does not – meaning there is divergence between the price movement and RSI – it may signal that the trend is not strong, and that a reversal may be imminent. If candlestick patterns confirm, a trader can use this as an opportunity to enter a position.
