Lesson 24 – Relative Strength Index (RSI) for Forex Traders
The Relative Strength index, most commonly referred to as the RSI, is a momentum indicator used by forex traders in their technical analysis to measure the strength of the recent changes in price.
It is a popular tool, most commonly used to have a quick reference to read the market momentum and sentiment. You will find many high performing traders just using this indicator just with a couple moving averages and always drawing in support and resistance lines. No need for more fancy stuff.
It is quite simple to understand and has a very simple information output which makes it easy to follow and to incorporate into your trading strategy.
What is the Relative Strength Index?
The RSI is an oscillator in our charting software with a value from 0 to 100 and will look something like this at the bottom of your chart.
The blue line you see on the indicator shows the RSI which expresses what level the market in currently trading at historically.
The RSI rises when the number and size of long trades rises and vice versa for short trades.
So the more buyers there are in the market, the higher the RSI.
And the more seller you have in the market, the lower the RSI.
As mentioned, the RSI sits anywhere between 0-100, and we focus on two important levels on this scale when using it as our trading indicator.
As you see in the picture above, we have two lines showing “overbought” and “oversold”.
An Oversold Market (Low RSI)
When the RSI falls below 30, the market is considered to be oversold. And the more oversold the market is, the more likely it is the price will rebound and the price will go up.
An Overbought Market (High RSI)
The opposite is true when the market RSI level rises above 70. Here, we consider the market to be overbought and we assume the market is more ready to weaken and that the price will head back down.
The higher the RSI goes, the more likely it is that the price will weaken.
This is all based on the assumption that “what goes up, must come down”. Which in most cases holds true. We just don’t know exactly when and by how much.
The RSI is a great tool for confirming trend or recognising when the market may be ready for a reversal. If the RSI reaches overbought or oversold conditions, you should look for other congruent indicators to help you plan a trade and enter a position.
As an example, you’d see that the market is about to hit a resistance as well as seeing the RSI at 70 which confirmis it being overbought. These would be ideal conditions to set up a short trade as you have two strong, congruent indicators.
Another angle to the RSI is its divergence. With many traders using this in their trading strategies, it would be wise to learn and understand then choose whether to integrate it into your trading strategy.
As you may have noticed already while working with your demo account, with certain currency pairs, you will see the RSI dipping into overbought and oversold quite frequently.
If your strategy would be to go long when the market is oversold and short when overbought, then you would be entering in far too many trades.
For most successful traders, the RSI is never enough as a standalone indicator and is used as a supporting indicator, often to check whether their previous assumptions about a trade are solid.
Luckily, there is a further level of depth in the RSI. Not only do we see when the market is oversold or overbought, but we can also look for bullish or bearish RSI divergence which indicate trend reversals in the market.
What is RSI Divergence?
It is worth noting that the RSI is simply a derivative of what is currently happing in the price action in th market. It is a reflection of past market prices and shows the relative strength of the price historically.
Most of the time, we will see the RSI mirrors the price action. However, there are cases where it does not follow the price direction and we find strange signals in our RSI. This is what we call RSI divergence and this can be used as a powerful and reliable indicator.
Bullish RSI Divergence
You find a bullish divergence when the RSI hits the oversold region making a “bottom”, this is then followed by a higher “bottom” (the RSI goes back up), while the market price action is doing the opposite and is still going down, making lower “lows”.
Put more simply, the market is hitting further lows while the RSI is indicating that the market is strengthening. This is divergence, two conflicting signals.
This indicates a high and rising bullish momentum and once the price breaks back out of the oversold region of the RSI (when it crosses 30), this is a strong signal to enter a long position as the market will be very likely to rise.
Bearish RSI Divergence
Bearish Divergence is the opposite of bullish divergence. You have it when the RSI reaches the overbought zone and makes a high followed by a lower high while the price action keeps making higher highs.
This is a strong indicator that the upward trend is running out of steam and that the market sentiment is ready to change.
This would be an excellent first indicator to enter a short position in the anticipation that the market will fall. This is especially powerful when you see the price action reaching a resistance level.
Most of the time you will find the RSI in line with the market and it can be used as a suggestive indicator to see a general market sentiment. RSI divergence is far more rare and can be taken as a much stronger indicator to help plan a trade around.
As always, it is best to have various congruent technical indicators pointing to the same conclusion before making trades.
Coming Up Next
Next, we will have a look at the MACD, an advanced and very popular moving average derived indicator, also very popular with many traders. Definitely a staple in every forex traders education.
See you there.