The relative strength index, or RSI, is a price momentum indicator in the same family as the moving average convergence divergence (MACD) and stochastic oscillator. Like other momentum indicators, the RSI is charted on a separate graph adjacent to price and has an oscillator range between 0-100. Most traders use the RSI to identify overbought and oversold market conditions and locate trade entry and exit points, but it can also be used as a divergence indicator.
Comparing RSI vs. Stochastic Oscillator
Given their similar objectives, shapes, and graphic ranges, it can be easy to confuse the RSI with the stochastic oscillator—and for good reason. Both indicators look at current closing prices relative to highs and lows over a stipulated look-back period. In addition, both indicators define overbought and oversold levels that traders use to identify buy and sell signals. The table below shows how the two indicators compare.
The differences between the two indicators are subtle and can best be understood by examining their respective formulas. The stochastic oscillator examines an asset’s current closing price (C) in relation to its price range of highs (H) and lows (L) over a 14-day look-back period to determine if the asset is overbought or oversold (or what’s known as the %K value).
In contrast, the RSI uses relative strength (RS)—or the average gains versus average losses of the previous 14-day period—to determine if an asset is overbought or oversold. In effect, both indicators are looking at previous highs and lows to determine current price momentum, but they focus on different relationships therein.
It’s also important to note that the stochastic oscillator consists of two lines, while the RSI forms only one. The second stochastic oscillator line (%D) represents a three-day simple moving average (SMA) of %K and is used as a signal line. The overlapping of these two stochastic signal lines is known as a “crossover” and is unique to the stochastic oscillator.
While the default overbought and oversold levels are different for each indicator, traders sometimes choose to change the RSI defaults to 80 and 20 (the same as the stochastic oscillator) for more volatile markets to reduce the occurrence of false signals.
Advantages of Using RSI in Forex
The popularity of RSI as a forex indicator is a product of its distinct advantages as a research and evaluation tool. Top benefits of using RSI include:
- It utilizes a simple mathematical formula. Unlike other technical indicators, the math behind RSI is simple enough that traders could do it by hand, if necessary. While it’s always better to use a live chart that tracks RSI in a visual format, traders may find comfort in knowing exactly what these insights are based on.
- It offers easy chart analysis. Because the overbought and oversold levels of RSI are clearly delineated, the indicator is very easy for even beginner traders to use—but still accurate and insightful enough that veteran traders will continue to rely on it.
- It provides simple notifications for identifying trade opportunities. Most traders use RSI to signal potential trade opportunities rather than relying on them as a sole indicator to initiative trades. As a result, many traders will set notifications for currency pairs that are activated once overbought or oversold conditions develop. This helps traders stay on top of evolving forex trends without missing out on new potential trades.
Disadvantages of Using RSI in Forex
For all of the value RSI offers to forex traders, it isn’t foolproof. While many disadvantages of RSI are exacerbated by misuse of this indicator in your trading strategy, there are certain limitations to keep in mind, including:
- RSI isn’t a great tool for confirming or executing trades. Most forex traders find RSI most valuable as a preliminary indicator that identifies trade opportunities and prompts further research and evaluation. This is because RSI does a great job of identifying overbought or oversold conditions, but it doesn’t offer the context needed to determine why or whether these conditions reflect a good trading opportunity.
- The time line for price reversals can be unpredictable. Even when RSI correctly predicts price reversals, conditions can remain overbought or oversold for days—far beyond what some traders are looking for.
- RSI can become less accurate when forex trends are strong. While RSI may still offer some value in strong trends, it should be used with extra caution.
Reading an RSI Graph
If you’re using the default RSI overbought and oversold settings, a signal line movement above 70 indicates that an asset is overbought, and a dip below 30 suggests that it’s oversold. If the RSI moves below 30 and then crosses back over the oversold line in the opposite direction, it’s thought to be a bullish (buy) indicator, with the expectation that prices will rise.
Conversely, when the RSI initially moves above 70 and then dips below this overbought line, it’s understood as a bearish (sell) signal, foreshadowing a drop in price.
In the NZD/GBP chart below, note how the oversold conditions in August are mirrored by an increase in price:
Those oversold conditions quickly swing up into overbought territory in September, after which the price drops and becomes range-bound in the immediate future. In both cases, RSI was accurate in identifying potential shifts in price momentum.
Using RSI to Spot Overbought Conditions
While RSI’s overbought and oversold signals are best read in the greater context of other validating indicators, even novice traders can start using this oscillator to spot preliminary trade opportunities based on overbought conditions.
We mentioned earlier in this article that RSI overbought conditions are typically defined as any instance where a forex pair’s RSI is greater than 80. When this happens, it suggests that the price for a pair has been artificially elevated by consumer demand for this position—meaning that, once the wave of demand dies down, the price is poised to drop.
Although traders should consider what other factors may be contributing to this price movement—including breaking economic and political news—the development of RSI overbought conditions could be used as a reliable starting point for deeper research into a potentially lucrative trading position.
How RSI Can Identify Oversold Conditions
In the same way that traders can easily identify RSI overbought conditions, a similar approach can be used to pinpoint oversold conditions likely to precede a price correction.
In most cases, the level at which RSI signals oversold conditions is marked at 20, as mentioned above, although some traders may decide to adjust this threshold based on their individual trading strategy. As with RSI overbought conditions, and oversold forex pair is one that has possibly seen its price pushed below market value due to widespread movement away from that position.
Oversold conditions could present an opportunity for traders to open positions at a discount, and steal quick profits through a swing trade once the price and RSI bounce back to normal levels. As always, traders are encouraged to develop a forex trading strategy that relies on multiple data points when considering the potential value of any position.
Recognizing Forex Opportunities
Overbought and oversold RSI readings are more accurate when price is trending sideways (indicating a strong trend) rather than erratically moving up and down. For this reason, traders using the RSI seek out trending markets that alternate between overbought and oversold levels but have sustained high and low periods, as is the case with the EUR/USD chart below:
To decrease your vulnerability to false signals, it’s always best to trade in the direction of the trend. After you’ve chosen a currency pair, trace or envision a trend line, and verify all buy and sell signals against the overall trend direction. In an uptrend, be on the lookout for a signal line dip below 30 followed by a rebound above 30. In a downtrend, focus your sights on peaks above 70 followed by dips below this line.
On the chart below, the RSI crosses over the overbought line on multiple occasions, producing a bearish signal. But if the trader were to act on the signal and bet against the trend direction, they would lose money long term because the overall trend remains upward.
Forex trading strategy favors averaging up and exercising resilience to small market fluctuations, so most traders invest with the trend to improve net profit. In short, they exit the trade only when the trend truly moves against them, as confirmed by sustained higher highs or lower lows in price.
In the AUD/USD chart below, notice how multiple reaches up into overbought territory go against the overall upward trend of the currency pair. These false sell signals could cost traders profit if they don’t use other indicators and chart patterns to corroborate and contextualize RSI data:
You’ll notice that the bearish signals produced by RSI are not entirely “false” in every instance. In other words, these movements sometimes correspond with a temporary drop in price. But the bearish signal doesn’t reveal itself until the RSI drops below 70, at which point the window for profit is fleeting. If a forex trader chooses to invest against the trend and sell, they may benefit if they place a stop close to the entry point and exit with a profit before the uptrend continues.
Understanding Failure Swings
Failure swings refer to instances when the RSI crosses over the overbought or oversold line, reverses to the opposite side, and pulls back again—this time without crossing over the line. The “swing” ends when the RSI breaks its recent low or high and continues to trend in the same direction.
Failure swings indicate that the price trend will reverse; swings at the top of the RSI range (70) are considered sell signals, while swings at the bottom (30) of the RSI range are considered buy signals. When a failure swing occurs, the RSI trend line will also break. For this reason, some traders choose to draw trend lines on the RSI oscillator to act as leading reversal indicators.
Pairing the RSI with Other Indicators
Because understanding trend direction is key to reading RSI signals, this indicator is often paired with other trend-following tools such as simple moving averages and trend-confirming tools such as the moving average convergence divergence (MACD) indicator.
In the case of MACD, RSI can be corroborated when overbought conditions are paired with MACD’s identification of divergence from price. The alignment of these two indicators is a popular and effective tool for identifying a trade opportunity.
Similarly, overbought conditions identified by RSI can be verified by the use of average directional index (ADX)—specifically if ADX is trending toward a retracement.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.