Want to learn how to use RSI Indicator in forex? The RSI indicator is a momentum oscillator, and it is one of the top forex trading indicators.
It can measure the speed and change of price movements. J. Welles Wilder developed it.
It measures the magnitude of recent closing prices and then uses this info to predict reversals; changes in trends.
The RSI indicator predicts these reversals by plotting readings in overbought and oversold regions which are within a range; of 1-100.
RSI Buy and Sell signals
When the reading given by the indicator is 70 and above, the commodity is overbought. This shows that buying pressure may not be sustained anymore.
Conversely, the commodity has been oversold when the indicator gives a reading of 30-level or lower.
Generally, sells are taken in the overbought region, while buys are taken in the oversold region.
RSI Indicator Formula
The RSI has two formulas.
The average percentage gain or loss over a period is used to calculate the average gain or loss in the computation.
The average loss is multiplied by a positive number in the calculation. When calculating average gain, periods of price declines are treated as 0; similarly, periods of price increases are treated as 0 when calculating average loss.
An initial RSI value is calculated using 14 periods. If the market had finished higher seven out of the last 14 days, with an average gain of 1%, this would be considered a positive market trend.
The market fell for the next seven days in a row, losing an average of 0.8% each time the market closed.
The calculation for the first part of the RSI would look like the following expanded calculation:
The second formula then smoothens the first:
Calculation Of The RSI
The RSI may be computed, and the RSI line displayed alongside an asset’s price chart using the procedures above.
Positive closures lead to an increase in RSI, whereas losses lead to a decrease in the RSI indicator. This is because the second component of the computation smoothes out all the data such that only highly moving markets would get an RSI reading near 100 or 0.
How To Interpret The RSI Indicator
The RSI helps to evaluate the overall position of the market, which significantly influences market decisions.
When the RSI plots readings rise above the 50-level, it signals the start of an uptrend. If the reading goes beyond 70, this means that the bullish trend might come to an end soon.
If buy positions were previously open, this is a signal to close these positions.
However, during strong trends, the oscillator can remain in the overbought and oversold regions for prolonged periods.
Furthermore, The RSI tends to stay above 30 and should regularly reach 70 during an uptrend.
It is unusual to see the RSI rise above 70 during a decline, while the indicator regularly falls below 30.
Use these criteria to assess the current trend’s strength and identify possible reversals.
After many price swings in an uptrend, the RSI can’t hit 70, which means the trend has weakened and might be about to reverse lower. RSI is one of the best indicators for swing trading.
How To Trade With The RSI Indicator In Forex
Just like the stochastic oscillator, the RSI can be traded with overbought/ oversold regions and divergences.
When the RSI plots value is above 70, the commodity is overbought. Most likely, bullish pressure cannot be maintained anymore, which is a sell signal.
In the example below, the RSI plotted readings above 70. A sell is taken at the point marked on the chart.
In the example above, the RSI’s reading is above 70, an overbought region. Typically, a sell position is taken here.
RSI readings below 30 signify the currency pair is oversold. In most cases, a bullish reversal occurs.
Apart from using the overbought and oversold regions for trading decisions, divergences can also be used.
A divergence occurs when the RSI indicator forms highs and lows that diverge from the current highs and lows on the price.
A bullish divergence occurs when the RSI forms two rising lows, but the price forms two falling lows.
While a bearish divergence occurs when the RSI forms a series of two falling highs corresponding with two rising highs on the price.
RSI vs. Stochastic Oscillator
Although both of these seem the same at first glance, they do have slight differences.
The RSI and the stochastic both display over-bought and over-sold regions. But unlike the stochastic oscillator, RSI tracks over-bought and oversold regions using the velocity of price movements and current price levels.
The RSI indicator is lagging. Lagging indicators are indicators that stall behind current price action.
This indicator lags because it compares recent price gains against price losses.
However, the RSI indicator can be viewed as a leading indicator as it is used to predict new trends.
The RSI indicator plots values between a scale of 1-100. So, the commodity has been oversold when the indicator gives a reading of 30-level or lower.
A general rule is to open sell positions when the RSI oscillates in the oversold region.
A moving average of a short period can be used in conjunction with the RSI. This moving average will validate buy and sell signals of the RSI via cross-overs.
Summary; How To Use The RSI Indicator In Forex- Definitive Guide
To be a successful trader, trading trends should be favored over reversals. Trading trends offer more security to capital, and profit is maximized.
The RSI only predicts reversals which makes it flawed. This is a big issue, as it can cause huge losses. Therefore you should combine the RSI with a trend indicator.
This way, you can have a trend-moment trading system, which offers more flexibility.