The relative strength index is a technical indicator that falls under the category of oscillators. Oscillators in Forex trading belong to a class of indicators that are plotted below the price chart in a sub-window. As the name suggest, oscillators tend to oscillate within a range such as 0 to 100 or -100 to +100 and so on. The zero-line is the most important aspect as oscillators can give out buy or sell signals as well as crossovers when two variables are used.
The relative strength index is a momentum indicator. Developed by J Welles Wilder, the relative strength index, or RSI for short, measures price momentum. The RSI conveys how much further a price is likely to continue to rise or fall in the same direction.
RSI works on the broader principle of physics which states that a body continues to move in the same direction in which the energy or force is applied until the momentum wears out. When momentum stalls, you can expect the price to either stall, move in a sideways range, retrace, or even change trend.
This concept is roughly translated into overbought and oversold levels, or OBOS, as they are commonly referred to. When an oscillator moves to an overbought level, it indicates that momentum is strong. When the oscillator moves away from the overbought level, it signals that momentum is falling. In such cases, prices are more likely to retrace.
Similarly, when the oscillator falls into an oversold level, it indicates strong downside momentum. Prices are more likely to continue falling when the oscillator is oversold.
When the oscillator reverses from the oversold level, it indicates that momentum is slowing and the price could make an upwards correction (in the opposite direction).
How is the RSI calculated?
In the good old days, traders had to manually calculate RSI values. Today, however, this has become much easier; as the RSI and other indicator values are now calculated automatically.
Still, it is important for traders to understand the mathematics behind the RSI calculation.
The RSI formula is 100 - [100 / (1+RS)]
The above formula might seem complicated, but it’s really very simple.
The RSI's values can be broken down into three main components; the relative strength, the average gain, and the average loss.
The first average gain is the sum of the gains from the last N periods divided by N, while the first average loss is the sum of the losses from the last N periods divided by N.
So, for example, if you use a 14-period RSI, then the first average gain or loss would be the sum of the gains or losses made over the 14 periods, divided by 14.
Once you’ve calculated the first averages, the next step involves calculating the smoothed averages based on the first averages and the current gain or loss.
These variables are derived by multiplying the previous average gain by (N -1) periods (ex: 13, when you use a 14-period RSI) and then dividing by N.
The RS component is derived by dividing the average gain by the average loss. The first average gain divided by the first average loss give us a value for RS. The second calculation will give us a smoothed value of RS, which is the value that is used in the original formula above to calculate the RSI.
In the above example, you can see how the RSI indicator is plotted, with rises and falls depicting the rise or fall in momentum.
How to trade using the RSI
There are many ways of trading using the RSI. The most common method is the overbought and oversold levels that are represented by the RSI indicator. Despite their simplicity, the overbought and oversold levels are widely misunderstood.
Traders think that they can sell or buy when the market is overbought or oversold. This can lead to serious losses in your trading as some context needs to be applied. In the next section, we explore this principle in a bit more detail.
RSI as overbought and oversold levels
When the RSI is above 70, it represents an overbought level. However, just because the RSI is above 70 doesn’t mean that price will reverse. Momentum can continue for a brief or prolonged period of time.
In figure 2, you can see the price levels when the RSI was above 70, suggesting an overbought level. Here, the price continues to push higher despite the RSI staying above 70. Even when the RSI slips below 70-level, you can see that the price only makes a modest dip before resuming the rally.
Similar to the example in figure 2, you can see in figure 3 how the oversold levels on the market don’t necessarily mean that price will retrace. Despite the RSI falling below 30 and subsequently rising, you can see that price continued to post a steady decline. The RSI is simply telling us that the momentum is easing, which is reflected by the somewhat ranging price action. Eventually, after a bottom is formed, the price starts to reverse the direction of the trend.
Thus, traders shouldn’t immediately go short when they see an overbought level or go long when they see an oversold level. Rather, the entire market context needs to be taken into consideration. Overbought and oversold levels (OBOS) need to be treated with caution, especially when market trends are strong.
In figure 4, we can see how, in the case of a sideways-trending market, the RSI’s overbought and oversold levels make a lot more sense. After the price establishes a range, the RSI’s overbought and oversold levels coincide with price bounces off the upper and lower boundaries of the established range. Thus, the RSI’s OBOS are best used when the markets are moving in a sideways trend. Making the mistake of using the OBOS levels in a trending market can result in serious losses, which can be easily avoided by just looking at the market in question.
In conclusion, the relative strength index is one of the most famous and widely used indicators on financial markets. The RSI measures a price’s momentum. Momentum is a leading indicator as it suggests how much further the price will continue in a given direction. Strong momentum suggests that the price will continue in the direction of the trend, while weak momentum suggests that the price will most likely retrace.