Introduction to RSI (Relative Strength Index)
The relative strength index is a momentum oscillator and is the one most used oscillators by traders. The RSI indicator was invented by J. Welles Wilder Jr. The indicator is used to identify overbought levels, oversold levels, divergences and failure swings. The indicator is usually set for a period of 14 days although the length of the period can be changed. A shorter time period will imply that the indicator will fluctuate greatly but over a long time period, the indicator will be smoothed out. There are two important levels on the indicator, one is 70 and the other is 30. If the RSI indicator rises above 70 then the region is overbought and if the indicator goes below 30 then the asset is oversold. It is measured on a level from 0 to a 100.
We can develop a simple strategy using the RSI indicator. If the asset enters the overbought region then a short position should be considered. Moreover, if the asset enters an oversold region, then a long position should be taken. We have shown an example using the pair EUR/GBP:
We have highlighted the areas on the indicator where buy and sell orders have been placed. The red rectangles are sell orders and the green rectangles are buy orders. As we can see this is a general strategy. When the asset has entered the overbought region, the price of the asset has fallen and the price has increased when it has been oversold. This is a fairly simple strategy.
Another use of the RSI is divergence of which there are two types – bullish and bearish. We shall first consider a bearish divergence and for this we have shown an example using the pair USD/JPY:
A bearish divergence is when the asset makes higher lows (bullish stance) and the indicator makes lower lows (bearish stance). This means that there exists a potential for a reversal to happen to the pair. In a bullish divergence the opposite happens, the asset makes lower lows whilst the RSI indicator makes higher highs. However, it should be noted that divergence can be misleading so it is advisable not to base your analysis of the market solely on divergences. This is because the strength of the trend may overcome the signals given by the indicator.
We next look at failure swings. There are two types of failure swings, bullish failure swings and bearish failure swings. We shall first look at bullish failure swings. We have shown an example of this by using the pair NZD/USD and we have highlighted the region in the indicator:
As we can see the pair is below 30 (oversold region) and the pair then bounces off the 30 level. The pair then pulls back but the indicator stills remain above the oversold region and then we see the indicator break prior highs. A bearish failure swing is when the asset is in an oversold region i.e. above 70 and we then proceed to see a pullback below the level of 70. The indicator then displays a lower high below 70 and we see the asset break a previous low.
RSI is a world-renowned indicator, but the indicator can sometimes falter, especially during divergences. What you see in the market may not actually happen due to the strength of the bulls/bears. In addition, RSI should be used in conjunction with other indicators and fundamentals. This may reduce your losses as you will be looking at the bigger picture.
CFDs, spread betting and FX can result in losses exceeding your initial deposit. They are not suitable for everyone, so please ensure you understand the risks. Seek independent financial advice if necessary.
Nothing in this article should be considered a personal recommendation. It does not account for your personal circumstances or appetite for risk.