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 and 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.
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 price 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 is comprised 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 instance of false signals.
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.
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.
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 trendline, 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.
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.
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 trendline will also break. For this reason, some traders choose to draw trendlines 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 MACD indicator. For the best results, invest with the trend, and confirm buy and sell signals, trend strength, and trend reversals with other analytical tools to reduce your vulnerability to false signals.
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.