Relative Strength Index (RSI) - The Complete Guide

Introduction

Relative Strength Index (RSI) oscillator was developed by J. Welles Wilder

RSI is one of the commonly used momentum indicator (oscillator) for technical analysis. Please note that the following explanation for the usage of Relative Strength Index is focused for Forex trading but the same is equally valid for stocks or any commodity trading.

How To Trade With RSI?

The signals RSI or Relative Strength Index generates are for overbought and oversold positions. Please note that overbought and oversold situations should only be analyzed when market is running into range and there is no clear trend.

  1. RSI Indicator - Overbought situation: RSI suggesting that its time to short sell.
  2. RSI - For oversold situation : RSI suggesting that its time to buy.

As mentioned above, please note that RSI (relative strength index) works well when the market moves in range but gives false signals when the market is in trend i.e. Bullish (uptrend) or Bearish (downtrend). You may use ADX for analyzing if the market is in range or has a trend.

RSI readings range from 0 to 100.

  • When the RSI nears 30 or goes below 30, the signal is that the currency pair is oversold and it may be the time to buy the pair.
  • When RSI nears or crosses 70 and goes below, the signal is that the market is overbought and it may be the time to short sell.

How to Use RSI?

RSI - example 1

In the above chart for EUR/USD at points A, B, C, D and E the RSI is either close to 70 or over 70. Points B, C, D, E (at the bottom of the chart) are when the market is running in the range (sideways). By range we mean that there is no up or down trend.

The yellow vertical lines are connecting these Relative Strength Index (RSI) levels to the prices on the candlestick chart above.

If you see the corresponding points A, B, C, D, E on the chart (top) you will see that the prices are going down after touching these points. So if would have we short-sold when the prices were at A, B, C, D or E, it would have generated profits as the market went down subsequently.

Similarly the points X, Y (at the bottom) are where the RSI was either nearing level 30 or had gone below the level 30.

The red vertical lines are connecting these RSI levels to the prices on the chart above.

If you notice the corresponding points X and Y on the candle-stick chart (top) you would see that the market bounced back subsequently i.e. gone up after touching these points (points X & Y). So if we bought when the prices were at X or Y, we would have ended with profits as there was an upward move afterwards.

When to Use?

RSI should be used when there is a sideways movement without a trend.

You may use ADX to see if market is moving sideways (ADX below 25) and then use .

RSI and ADX:

RSI - example 2

RSI Trading Strategies

Cautious approach:

  • Buy when RSI goes up the 30 mark, take a small dip again and come below 30 again (as small correction) and then comes back up little over 30. Take profit when the market moves up.
  • Sell when RSI goes below 70 mark, takes a correction to go up again and then comes below 70 again.
  • Buying and selling at the first crossover/signal is never advisable and we should wait for a correction and reconfirmation.

It is possible that when the RSI is going up, it does not cross or touch the level 70 but starts going down from a level below 70 e.g. from let's say after it reaches the level 65.

Similarly It is possible that when the RSI is going down, it does not cross or touch the level 30 but starts going up from a level above 30 e.g. from let's say after it reaches the level 35.

In such cases we might miss the chance of entering market and if you are ready to take more risk then you can enter the market just below 70 (short-selling), when RSI is going up or just above RSI 30 (buying), when RSI is going down.

Period setting for Relative Strength Index

The quite preferred setting for the RSI is 14 periods, which means if we were to calculate RSI on a daily chart we would measure 14 days, and in the case of an hourly chart, we would measure 14 hours. The default setting of 14 is common to several popular indicators including ADX which has been mentioned in this explanation.

Check some thoughts about combining RSI and ADX
RSI with ADX, stochastic and Bollinger Bands
RSI with ADX, SAR and MACD

We explained RSI (Relative Strength Index) indicator for technical analysis the context of Forex Trading but the same stands good for stock trading or any commodity trading.

 

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