The relative strength index (RSI) is a popular technical analysis indicator used in many investment strategies. The RSI helps investors identify market moves and overbought or oversold situations. The RSI indicator is plotted in a separate chart on the price chart for a particular value. The indicator consists of a single line and two levels that are set automatically.
The RSI vertical axis runs from 0 to 100 and indicates the current price compared to previous values. If the price rises to 100, this is a very strong uptrend as usually anything above 70 is considered overbought. And if the price falls to 0, this is a very strong continued downtrend as anything below the 30 level is considered oversold.
What is RSI in Forex? This Forex strategy is based on exploiting the market traces between these price levels. However, it is important to use the indicator as part of a broader strategy for confirming entry and exit points, as sharp price movements can cause the RSI to send false signals.
How to Calculate the RSI Indicator?
The Relative Strength Index (RSI) is an indicator that can help determine buying or selling times of, for example, stocks. With the help of the MFI, the "enthusiasm" of the market can be mapped. The RSI indicator measures the speed and direction of a movement. The indicator is used to signal so-called "overbought" or "oversold" situations.
The following formula is used for the calculation:
RSI = 100 - (100 / (1 + (average rise / average fall)))
To calculate the average rise and fall, each day's closing price is compared with the closing price of the day before. When the closing price is higher than the closing price of the day before, the increase (the difference between the two closing prices) is added to the risers. The sum of all these increases is then divided by the number of days on which the calculation is based.
Conversely, when the closing price is lower than the closing price of the day before, the fall (the difference between the two closing prices) is added to the fallers. The sum of all these decreases is then divided by the number of days which the calculation is based on to obtain the average decrease.
How Can You Use the RSI Indicator?
There are several ways to use the RSI. The indicator is often used to signal "overbought" or "oversold" situations.
With an RSI value above 70, there is an “overbought” signal. The share has risen (too) fast and the chance of a counter-reaction is increasing based on this indicator. Below a value of 30, there is an “oversold” signal. Some traders prefer to use the 80 and 20 as the starting points for a signal. In this way, the indicator gives fewer signals, which should benefit the margin of error. The underlying idea of the indicator is that with an “overbought” signal the stock has risen too fast, so that at that moment, based on the RSI indicator, it is not a good time to also buy.
In the event of an “oversold” signal, the stock would have been punished too harshly, which made entry more attractive. Oftentimes, this indicator is used by day traders to enter a contrarian position for the short term. With a high RSI, a short position is taken, and a long position is taken with a low RSI.
What many investors and traders often forget is that an RSI over 70 is often also a sign of strength. Many investors buy the stock, so there is a good chance that the stock will continue the upward trend. Obviously, the opposite applies to an RSI below 30. The overbought and oversold indications seem to work especially well in sideways trends. In case of a rising or falling trend, it is better to look at divergences.
Divergences with the RSI Indicator
In our opinion, divergences are the most important part of both the RSI and the RSI indicator. Identifying divergences also gives the best results when using the indicator. In technical analysis, these divergences are used for various indicators. There is both positive divergence and negative divergence.
Positive divergence occurs when the RSI rises while the price of the underlying asset falls. This divergence indicates that the downward movement's force is diminishing and may signal a potential bottom and/or trend reversal of the stock at an early stage.
Negative divergence occurs when the RSI falls while the price of the underlying asset is still rising. This divergence indicates that the upward movement's strength is diminishing and may signal a possible top and/or trend reversal of the stock at an early stage.
The RSI is a valuable indicator to test your perception of the current market condition. Convergence confirms the current trend, while divergence indicates that the trend may reverse. By taking this into account, you can take positions more successfully and make more profit with Forex and stocks.
Moreover, the RSI is essential when taking a position on a trend reversal: it is wise to take a position on a trend reversal only in divergence. The RSI is, therefore, very useful when you want to open a position on a trend reversal.