Relative Strength Index (RSI)
Introduction to RSI indicator
Relative Strength Index (RSI) - is another great momentum indicator developed by Welles Wilder.
Standard period settings for RSI is 14 periods, which can be applied to any time frame.
Trading with RSI indicator involves the following signals:
• RSI moving above 50 level — uptrend is confirmed, below 50 — downtrend is confirmed.
• RSI peaking above 70 level — market is overbought.
Let's review each of these RSI signals below.
How to trade with RSI indicator
RSI indicator is often referred as an overbought/oversold indicator, however, this is not exactly accurate. RSI doesn't provide Buy/Sell signals upon reaching oversold/overbought areas, there are certain rules, which help to identify the right timing for entries and exits.
Readings above 70 indicate an overbought market, while readings below 30 indicate an oversold market.
In order to enter at the right moment (on the true market reversal) Forex traders should wait for RSI to leave its overbought/oversold area. For example, when RSI goes above 70, Forex traders would prepare to Sell, but the actual trade will take place only when RSI crosses down below 70.
Forex traders also use 50 level of the RSI indicator, which separates buying forces from selling forces on the market. Certain trading strategies use RSI 50 level to confirm Long and Short entries by looking at a positioning of the RSI in relation to its 50 level.
RSI trend lines
RSI indicator has got another handy feature: Forex traders use RSI to draw trend lines.
With RSI trend lines Forex traders are able to receive a much earlier warning about upcoming trend changes since RSI trend lines witness a breakout few candles earlier than chart trend lines.
Trading divergence with RSI indicator
Another way to exploit RSI is to take advantage of RSI divergence signals.
The best way to learn about any indicators is to read original works of their creators.
"(3) Failure Swings: Failure swings above 70 or below 30 are very strong indications of a market reversal. (See Fig. 6.3 and Fig. 6.4)"
"(5) Divergence: Although divergence does not occur at every turning point, it does occur at most significant turning points. When divergence begins to show up after a good directional move, this is a very strong indication that a turning point is near. Divergence is the single most indicative characteristic of the Relative Strength Index."
RSI indicator Formula
RSI = 100 - 100 / (RS + 1)
RS = Average Upward Price Change / Average Downward Price Change
Average Upward Price Change = [(previous Average Upward Price Change) x 13 + current Upward Change] / 14
Average Downward Price Change = [(previous Average Downward Price Change) x 13 + current Downward Change] / 14
For calculation Downward Price Changes are taken as positive values.