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The Relative Strength Index (RSI) is the most famous indicator used in Forex trading

What is the Relative Strength Index (RSI) indicator and how is it used in financial markets. Calculation of the RSI indicator and trading strategies.

Hello dear readers, investing in the global financial markets where large amounts of money are traded is becoming more and more technological and interesting every day. You can trade on these markets using just your internet-connected smartphone or laptop, no matter where you are in the world. You can trade currencies, commodities, stocks, funds, bonds, and other things in the 24/5 Forex and stock markets. You can also trade many different cryptocurrencies on crypto exchanges 24/7, at any time of day. Of course, in order to conduct successful trading, it’s necessary to learn about technical and fundamental analysis. Technical analysis holds an irresistible position in the Forex market. Whether you’re a beginner trader or a professional, you will always need technical analysis. This type of analysis covers many areas, and one of them is the demonstration of indicators. Indicators are an essential part of technical analysis. In this article, we will discuss the most well-known and widely used indicator, the “Relative Strength Index” (RSI).

What is the Relative Strength Index Indicator?

The Relative Strength Index (RSI) is the most famous technical analysis indicator widely used in financial markets. RSI is a technical tool developed by John Welles Wilder, an American investor, writer, and mechanical engineer. It’s commonly used to identify overbought or oversold conditions of an asset and also to measure its momentum. This indicator is designed to determine the speed and change of price movements. Furthermore, it detects imbalances in the upward and downward movements of prices and evaluates the speed of correction for these imbalances. In his book titled “New Concepts in Technical Trading Systems” published in 1978, J. Welles Wilder introduced notable technical indicators like the Parabolic SAR, Average True Range (ATR), and Relative Strength Index (RSI). Since then, it has been the most preferred indicator by almost all traders. In particular, it serves as an indispensable compass for beginners.

How to calculate RSI?

When trading currencies, stocks, commodities, and other financial assets in Forex, the RSI assists us in making buy and sell decisions. RSI is calculated by evaluating the ratio of increases and decreases in an asset’s price over a specific time period. In the first step, consecutive closing prices within a defined time period are compared. Positive price changes (increases) and negative price changes (decreases) are calculated separately:

          Average Gain (Positive Close) = Current bar’s closing price – Previous bar’s closing price

          Average Loss (Negative Close) = Previous bar’s closing price – Current bar’s closing price

Average Gain. The average gain represents the average of price increases within a specific time period. First, positive closing changes (periods when the price goes up) are calculated. Positive closing changes refer to the increase in closing prices over the previous day in consecutive days. Then, the sum of positive closing changes over consecutive days is calculated. This sum is divided by the number of days in the specific period (for example, for a 14-day RSI calculation) to obtain the average gain.

Average Loss. The average loss represents the average of price decreases within a specific time period. First, negative closing changes (periods when the price goes down) are calculated. Negative closing changes reflect the decrease in closing prices over the previous day in consecutive days. Then, the sum of negative closing changes over consecutive days is calculated. This sum is divided by the number of days in the specific period (for example, for a 14-day RSI calculation) to obtain the average loss.

Average Gain is the average of increases within a specific period, and Average Loss is the average of decreases. Afterwards, the average values of these positive and negative changes are calculated. The ratio between the average positive and average negative is called Relative Strength (RS). Relative Strength is used to identify overbought and oversold conditions.

                                        RS = Average Gain / Average Loss

The calculation of RSI is completed by scaling the Relative Strength using a specific formula to a range between 0 and 100. This scaling allows the RSI value to indicate how close the price is to the overbought or oversold zone. RSI usually takes a value between 0 and 100 and is calculated using the following formula:

                                        RSI = 100 - (100 / (1 + RS))

How to Trade with the RSI Indicator?

In addition to identifying overbought and oversold zones, the RSI indicator is also used to assess the momentum of asset prices and probable trend reversals. Therefore, RSI remains a powerful tool for understanding market movements and developing trading strategies.

The RSI value ranges between 0 and 100, with levels above 70 considered overbought and levels below 30 indicating oversold conditions. These ranges constitute one of the most serious uses of the indicator. In fact, overbought and oversold zones provide important signals that the price is likely to move in the opposite direction. When the RSI value rises above 70, mainly progressing into the 80-100 range, it signifies that the asset is in an overbought state. This indicates that the price has risen excessively and there might be a correction or a drop in the near future. In such cases, a Sell order is placed. Conversely, when the RSI value drops below 30, mostly reaching the 20-0 range, this is interpreted as a signal of a possible trend change in the price and is suitable for entering a Buy order. The 50 level in RSI values is closely monitored and plays a role as a support and resistance level. Crossing above 50 indicates bullishness, while dropping below 50 suggests strengthening bearish sentiment.

Trading the Forex market with divergences in the Relative Strength Index (RSI) indicator
Trading with the RSI in the AUD/USD chart

Like with other technical indicators, we also trade using divergences in the RSI indicator. When the price of any asset forms lower lows on the chart, but the RSI values form higher lows, this is called a positive positive divergence. It means we’ve caught a great opportunity for a Buy order. Particularly, when positive divergences occur near or below the 30 level, we consider it an extra and more reliable chance. On the other hand, if the price of the financial asset we’re trading forms higher highs while the RSI value forms lower highs, this is a negative divergence. This allows us to place a Sell order. If a negative divergence occurs closer to or above the 70 level, it’s like popping the champagne, signaling a celebration. See the example in the AUD/USD chart above.

Just think about this, don’t forget that the Forex market, with its high liquidity, carries an undeniable risk due to rapid price movements and extensive trading volume. Sudden price changes and fast market actions can promptly affect our positions and even lead to noteworthy losses. In financial markets, it’s crucial to never solely rely on the signal of a single indicator for trading decisions. While the RSI indicator might be highly preferred, it can sometimes fall short when used on its own. Therefore, please make an effort to combine technical indicators. Always remember to create a sound risk management strategy, carefully manage our capital, and remain prepared for sudden market changes. While high liquidity offers profitable trading opportunities, it’s wiser to avoid trading without proper education and the ability to conduct thorough analysis.

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