The Relative Strength Index (RSI) indicator for FX traders is essential when it comes to technical analysis. The vast majority of traders are using the indicator to spot overbought and oversold market conditions. Forex RSI indicator is a leading type, which means that it sends trading signals about upcoming reversals. The indicator is simple to use and very practical, for this reason, it’s highly popular among novice and professional traders.
RSI indicator overview
RSI is an oscillator that is frequently used in determining whether a forex pair is overbought or oversold. When the market is in an overbought condition, it means that we can sell the asset and vice versa.
The index measures price momentum on a scale of 0 to 100 and traders can analyze these results over set periods of time to gauge whether to go long or short. Although, RSI alone is not enough to base trade decisions on and works best when used in combination with other technical indicators or trendlines.
- RSI is a leading momentum indicator that measures whether a pair is overbought or oversold
- RSI is most often used on a 14-day time period
- MACD is frequently used alongside RSI – with the former showing when to buy/sell and the latter showing whether the instrument is overbought or oversold
- A drawback of RSI is that markets can remain overbought or oversold for extended periods of time. The indicator fails to produce reliable signals in trending market conditions
- RSI can provide buy and sell signals for short-term traders
- The indicator is usually attached below the chart for visual clarity
- Using RSI indicator trading Forex pairs is simple and easy to learn. Which makes it one of the widespread indicators among novice and professional traders
Technical details of the RSI indicator
There are two types of indicators in terms of trading signals they provide: leading and lagging. Leading indicators signal traders before trade reversal or establishment of a new trend happens. Lagging indicators show what has already happened, and they make prices better to digest visually.
RSI is a leading momentum indicator as it signals potential price reversals once price crosses overbought and oversold levels. While a useful indicator, RSI is often used in tandem with other indicators, as it can easily be influenced by large-volume trades in the short term.
How RSI works
The RSI indicator consists of a single line which is plotted below the price chart. The values provided by the RSI can be broken down into three levels:
- 0-30 – oversold
- 30-70 – neutral
- 70-100 – overbought
Keep in mind that the 30, 70 levels are standard and can be changed according to your preference.
RSI compares the strengths of trends when prices are moving up to the strength when the prices are going down. Combined with other indicators, RSI can provide insight into the possible price direction of a security, thus sending out buy and sell signals to traders.
To find the RSI value, a two-step calculation is needed:
RSI = 100–100/((1+(Average gain/Average loss))
The formula uses positive values for average gains and losses, which represent the percentage gains and losses over the look back period. Periods of gain are input as zero in the average loss.
For example, suppose the market closed with an average gain of 1.5% seven days out of the 14-day period, and an average loss of -0.5% on the remaining seven days. The formula would look like the following:
RSI = 100–100/[1+(1.5%/14)/(0.5%/14)]
RSI = 100–100/4
RSI = 75
The first calculation of RSI would indicate a strong trend and once the 14-day data was available, we can move on to the next step:
RSI = 100 – [100/(1+((Previous Average Gain X 13) + Current Gain)/(Previous Average Loss X 13) + Current Loss)).
FX trading RSI indicator can be used along with various indicators and simple trendlines.
RSI trendlines can indicate trendline breaks by connecting specific points on a price chart to the RSI line to show possible trend continuations or reversals. The example below shows the RSI trendlines of the GBP/USD pair.
RSI vs MACD
The moving average convergence divergence, or MACD, is another technical indicator that follows the trend to measure momentum. The MACD is calculated by subtracting the 26-period exponential moving average, or EMA, from the 12-period exponential moving average.
The difference between MACD and RSI is that the MACD measures the relationship between two exponential moving averages, while the RSI shows the price change momentum by comparing recent highs and lows.
Many analysts and traders use the two indicators in conjunction to get a clearer picture of the market.
While RSI can be a useful indicator to measure price change momentum, it alone is not enough to make educated guesses about the direction of the market and possible entry and exit points. The RSI indicator has some limitations, such as:
- Accurate reversal signals can be rare and hard to separate from false alarms
- Securities can remain within the overbought or oversold category for extended periods
- RSI alone does not indicate strong buy and sell signals and works best when used alongside other indicators, such as MACD
- RSI is a purely technical indicator, traders should take into account economic announcements or at least keep an eye on economic calendar to avoid placing technical orders before or during market announcements.
Practical application of the RSI indicator
To see how RSI works on a price chart, let’s take a look at the RSI indicator example.
In this example, the indicator closely follows the price movements of the GBP/USD pair, which was alternating between the values of 60 and 70 on many occasions, which signals that the pair could be overbought. This may be due to the ongoing uncertainty regarding the British pound and the buying spree after the GBP/USD pair fell to its lowest below 1.07.
History and other useful details of RSI
RSI indicator forex traders widely use today was introduced by J. Welles Wilder in 1978. RSI quickly became one of the most widely used momentum indicators and was tested against other strategies, where it performed favorably. While a useful short-term tool, the indicator falls short to the buy and hold strategy in the long run.
Another variation of the indicator, Cutler’s RSI, determined that the smoothed data used by Wilder was dependent on the starting point. To avoid this, Cutler’s RSI uses a simple moving average and is not dependent on the length of data. The formula for Cutler’s RSI is as follows:
RSI = (SMA (U, n))/(SMA(D, n))
Where U and D are simple moving averages.
FAQs on the RSI indicator in forex
What timeframe is the best for RSI indicator?
RSI typically uses a 14-day timeframe to analyze prices and indicate whether a security is overbought or oversold, and whether a retracement is likely to occur on the market. While it’s true that the 14-day timeframe is the most popular, you can change that number to fit the indicator to your trading strategy.
Is RSI a good indicator?
RSI is an effective technical indicator that shows the strength of a trend by the strength of its upward and downward movements. Every indicator is created to be used in certain market conditions. What’s great about the RSI is that it’s simple to understand and simple to trade.
Is RSI indicator for forex trading?
The RSI indicator is used in stock, crypto and forex trading. Forex traders frequently use RSI with other indicators to measure the momentum of a security’s price to find out its possible reversal points. FX RSI indicator is an important part of technical analysis.