Relative Strength Index (RSI) Formula – How To Trade Overbrought And Oversold

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Perfect For Beginners!
    Free Demo Account!
    Free Trading Education!
    Sign-up Bonus!

  • Binomo
    Binomo

    Trustful Broker!

How to Use RSI (Relative Strength Index)

Relative Strength Index, or RSI, is a popular indicator developed by a technical analyst named J. Welles Wilder, that help traders evaluate the strength of the current market.

RSI is similar to Stochastic in that it identifies overbought and oversold conditions in the market.

Typically, readings of 30 or lower indicate oversold market conditions and an increase in the possibility of price strengthening (going up).

Some traders interpret that an oversold currency pair is an indication that the falling trend is likely to reverse, which means it’s an opportunity to buy.

Readings of 70 or higher indicate overbought conditions and an increase in the possibility of price weakening (going down).

Some traders interpret that an overbought currency pair is an indication that the rising trend is likely to reverse, which means it’s an opportunity to sell.

In addition to the overbought and oversold indicators mentioned above, traders who use the Relative Strength Index (RSI) indicator also look for centerline crossovers.

A movement from below the centerline (50) to above indicates a rising trend.

A rising centerline crossover occurs when the RSI value crosses ABOVE the 50 line on the scale, moving towards the 70 line. This indicates the market trend is increasing in strength, and is seen as a bullish signal until the RSI approaches the 70 line.

A movement from above the centerline (50) to below indicates a falling trend.

A falling centerline crossover occurs when the RSI value crosses BELOW the 50 line on the scale, moving towards the 30 line. This indicates the market trend is weakening in strength, and is seen as a bearish signal until the RSI approaches the 30 line.

How to Trade Using RSI

RSI can be used just like the Stochastic indicator.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Perfect For Beginners!
    Free Demo Account!
    Free Trading Education!
    Sign-up Bonus!

  • Binomo
    Binomo

    Trustful Broker!

We can use it to pick potential tops and bottoms depending on whether the market is overbought or oversold.

Below is a 4-hour chart of EUR/USD.

EUR/USD had been dropping the week, falling about 400 pips over the course of two weeks.

However, RSI dropped below 30, signaling that there might be no more sellers left in the market and that the move could be over.

Price then reversed and headed back up over the next couple of weeks.

Determining the Trend using RSI

If you think a trend is forming, take a quick look at the RSI and look at whether it is above or below 50.

If you are looking at a possible UPTREND, then make sure the RSI is above 50.

If you are looking at a possible DOWNTREND, then make sure the RSI is below 50.

At the beginning of the chart above, we can see that a possible downtrend was forming.

To avoid fakeouts, we can wait for RSI to cross below 50 to confirm our trend.

Sure enough, as RSI passes below 50, it is a good confirmation that a downtrend has actually formed.

A traders guide to the relative strength index indicator

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.

RSI Trading Strategies

RSI Trading Strategies

RSI indicator (Relative Strength Index) is one of the main oscillators used in technical analysis. This instrument helps to assess pricing dynamics against the previous values.

RSI offers a chance to define the market sentiment and spot the points at which the market is overbought and oversold.

It is also used to detect times when the price is about to reverse, and a new trend rises.

Open your trading account at AvaTrade or try our risk-free demo account!

Table of Contents

Features and Advantages of The RSI Indicator

As any other oscillator, the RSI indicator is not plotted on the price chart, but in a separate window below. This technical instrument consists of a single line and two levels set by default.

Vertical axis range of the indicator is set to 1 to 100 showing extremality of current price against its previous values.

RSI values calculation

What the formula means, is that if the price grows against previous values, so does indicator reading; otherwise, oscillator’s value goes down.

The RSI line may reach 0 or 100 only during strong, continuous downward or upward trend, respectively.

Usually standard overbought and oversold levels are 70 and 30. If the indicator’s line goes above the 70 level, it signals that market is overbought and the trend may reverse downwards.

If the indicator’s line goes below the level 30, it signifies that market is oversold and the trend may reverse upwards.

The reference level is 50, and it is the median value. If the indicator chart is ranging between the levels 30 and 70, the market is flat or that the current trend is smooth, steady and there is less of a likelihood for reversal in short-term

Sometimes, overbought and oversold levels are set at 80 and 20 instead of 70 and 30. This setting is used during increased market volatility.

Setting and Adjusting RSI Indicator

There are two ways to set up this indicator. The easiest way is to click the tab ‘List of Indicators’ located on the upper panel of the terminal and select ‘Oscillators’ – ‘Relative Strength Index’.

Another option is to choose ‘Insert’ – ‘Indicators’ – ‘Oscillators’ – ‘Relative Strength Index’.

Instrument configuration window will open before the indicator is set in the chart. This window allows you to configure the indicators parameters.

The main parameter is the period; It defines the number of price values taken into consideration at plotting the main indicator’s line. The shorter the period, the steeper indicator’s chart movements will be.

This parameter is set to 14 by default, and this setting is considered optimal in most cases. You can also adjust the style settings, like line colour and weight.

By using another tab of configuration window, you can change parameters of the levels from 30 and 70 to 20 and 80. You can also add new levels should your trading strategy require so.

Open your trading account at AvaTrade or try our risk-free demo account!

Opening Positions on RSI Signals

The main signal the RSI oscillator generates allows defining overbought and oversold price ranges.

Although it is frequently used as a filter in systems where the main indicator is a trend one, it might be possible to try trading using RSI signals only.

When indicator’s line goes above the level 70 or below the level 30, it signals that market is overbought/oversold, and it is necessary to wait for the next signal confirming a trend reversal.

These are the rules for opening positions based on the RSI signals:

  1. If the indicator’s line crosses the level 70 from above, a short position (Sell) is opened.
  2. If the indicator’s line crosses the level 30 from below, a long position (Buy) is opened.

There are several conditions for closing a trade:

  1. Place a Stop Loss to local extremum and Take Profit to the value that is by 2-3 times greater.
  2. Exit on opposite indicator’s signal.
  3. Place a Stop Loss and Take Profit to the nearest key levels or Fibonacci (here Take Profit level should be not less than Stop Loss otherwise it is better to hold back and avoid opening a trade).

However, trading using RSI signals only is not the best approach as it has been designed to be used as a filter and not the main instrument.

A trading strategy will be more efficient when using a trend indicator or at least paying attention to the Price Action signals.

Combined Strategy using Stochastic + RSI

In order to boost trading efficiency, it’s best to use the Stochastic Oscillator. The absence of trend indicators in this trading strategy is compensated by simultaneous analysis of two timeframes.

This way the oscillators will filter each other’s signals and trades will be opened only when both indicators give the same signals on different time frames.

This strategy suggests using time frames of Н4 and М15. In Н4, the RSI will have the default settings.

The only difference will be that instead of levels 30 and 70 we will set it at 50. In М15, Stochastic will have default settings.

Short position (Sell) will be opened in the following case:

  1. In Н4, the RSI line is crossing the level 50 from below.
  2. In М15, Stochastic lines exit overbought zone and heads down.

Long positions (Buy) will be opened in the opposite case.

Stop Loss and Take Profit are fixed and set at distances 20 and 50 points from the opening price respectively.

Such ratio enables to obtain a positive statistical expectation from trading in the long run.

It is recommended to check the economic calendar before opening positions in this trading system since the release of important news can significantly influence price movement, and technical analysis won’t be relevant at this very moment.

Open your trading account at AvaTrade or try our risk-free demo account!

Advanced Strategy RSI + Stochastic + МА

Finally, let’s consider strategy with three classic indicators filtering each other as a single set and giving powerful signals for entering the market.

This strategy fits best for trading on Н1, Н4 and D1.

First, it is necessary to set up the following indicators in the chart:

  1. A moving average with the period of 10.
  2. An RSI with standard settings (levels 70 and 30).
  3. A Stochastic oscillator with standard settings (levels 80 and 20).

According to this strategy, a long position is opened when the following signals are generated:

  1. Price is crossing МА from below.
  2. RSI and Stochastic exit oversold zone.

All three signals should be received during three candles, otherwise, they will lose their value.

Short positions (Sell) should be opened in the opposite case.

Exiting an open trade should be done when RSI enters the opposite zone. Sometimes, an opposite position can be opened simultaneously with closing previous position, granting other signals to follow the aforementioned pattern.

Conclusion

The RSI is one of the main indicators of technical analysis, and almost all the forex trading experts think that it is still very useful and valuable as a source of trading signals.

The success of trading with an RSI depends on using additional indicators in conjunction with it.

Combined with the right indicators, RSI forms an efficient system, which can be fine-tuned by amending the parameters of instruments used.

Open your trading account at AvaTrade or try our risk-free demo account!

Trading in financial markets puts your capital at risk. It is recommended to accurately follow the money management rules and always set Stop Losses to reduce risks. This article doesn’t constitute an investment/trading advice.

We recommend you to visit our trading for beginners section for more articles on how to trade Forex and CFDs.

Relative Strength Index

Relative Strength Index, or RSI, is one of the most popular technical indicators among traders. It was developed by J. Welles Wilder in 1978 to measure the speed and the change of price movements. The indicator also helps to determine the overbought/oversold state of the market in order to buy low and sell high.

How to implement RSI

To add the RSI to a chart, click “Insert” – “Indicators” – “Oscillators” – and you will see the “Relative Strength Index”.

By default, MetaTrader will offer you to have “14” as the number of periods. You can change this parameter if you want to. Short-term traders normally use 9-period RSI, while those who prefer longer-term trades choose 25-period RSI. All in all, the smaller the period, the more fluctuations the indicator will make.

How to interpret Relative Strength Index

The readings of the indicator fluctuate between 0 and 100. You can also add a middle line at 50. If the RSI is above this point, momentum is considered up and there’s more sense to look for opportunities to buy. When the RSI drops below 50, it’s a sign of a new bearish market trend, so consider opening sell trades.

The market is overbought or oversold

Like other oscillators, the RSI helps to tell when the asset is overbought or oversold. For the RSI, you need to watch the levels of 70 and 30. If the RSI rises above 70 bound, it means that the market is overbought and may correct down. If the RSI falls below the 30 line – the asset is oversold and may retrace to higher levels.

Notice, however, that this approach is not suitable for trading in strong trends when the RSI may stay overbought or oversold for long periods of time. If you have evidence that there’s a strong trend in the market, consider selling when RSI is oversold in a downtrend, and buying when RSI is overbought in an uptrend.

All in all, the quality of RSI signals increases when you follow only those signals that are in the direction of the trend when the indicator leaves critical levels. For example, you can buy during an uptrend when RSI gets above 30.

The market reversal

Moreover, the divergence between RSI and price may warn of the market reversal. When the new high of the price is not confirmed by the new high in the RSI, it’s a bearish divergence, which is a negative signal. When the price forms a lower low but the minimum of RSI is higher than the previous one, it’s a divergence in favor of bulls.

The RSI is often used in combination with another oscillator, the MACD. While the RSI measures price change in relation to recent price highs and lows, the MACD measures the relationship between two EMAs. Together the RSI and the MACD represent a powerful combo.

Conclusion

A competent trader should know what the RSI is and how to use it. Make sure that your analysis isn’t built solely on RSI but comprises the study of price action as well as other technical indicators. Remember that the signals of the Relative Strength Index are most reliable when they conform to the long-term trend.

Best Binary Options Brokers 2020:
  • Binarium
    Binarium

    The Best Binary Options Broker 2020!
    Perfect For Beginners!
    Free Demo Account!
    Free Trading Education!
    Sign-up Bonus!

  • Binomo
    Binomo

    Trustful Broker!

Like this post? Please share to your friends:
Binary Options Wiki
Leave a Reply

;-) :| :x :twisted: :smile: :shock: :sad: :roll: :razz: :oops: :o :mrgreen: :lol: :idea: :grin: :evil: :cry: :cool: :arrow: :???: :?: :!: