2021-02-22
2021-02-22
RSI Indicator - Relative Strength IndexOleg Tkachenko
The relative strength index is an oscillator widely employed in technical analysis. Many Forex trading strategies for beginners use it as a tool to confirm signals to buy or sell. It works like a stochastic oscillator, [MACD][1], and CCI. There also used the modifications, such as Silent RSI, RSI Divergence, and others.
The article covers the following subjects:
The article is going to be useful, engaging, and to the point!
The Relative Strength Index (RSI) was developed by J. Welles Wilder, the author of another standard indicator for МТ4 and МТ5, the ATR indicator.
Wilder first published the description of the RSI indicator in Commodities magazine in 1978. A few years later, his book New Concepts in Technical Trading Systems was published, where he described the technical tool in more detail, using practical examples.
What does relative strength index mean? According to the RSI definition, it is a momentum oscillator that measures the velocity and magnitude of price movements. It is a dynamic line moving in the scale from 0 to 100. The indicator compares the closing prices of the current and the previous candlesticks, indicating the trend strength. How to read the RSI indicator?
The relative strength index charts work as follows:
The stronger is the relative price movement up, the greater is the total value of rising candlesticks, and the stronger is the uptrend. The oscillator line is close to value 100.
The stronger is the relative price movement down, the greater is the total value of descending candlesticks. So, the stronger is the downtrend, the closer the oscillator line to 0.
The oscillator is displayed in a separate window under the trading chart.
Horizontal dotted lines are signal lines, whose parameters are specified in the settings. The values of 30 and 70 are by default; the levels scale is on the right of the chart.
These zones are strong as the trend and the oscillator are the most likely to reverse.
If the trend is clear, the levels of the borders of the range can be moved to 20 and 80. Levels 30 and 70 are used if the trend is weak, or the market is trading flat. The longer is the distance between the signal levels, the less frequent are signals. One the other hand, the signals are more accurate in this case.
You can employ the indicator in any market. It is equally efficient in the Forex trading charts, in the securities or stock markets.
What does the RSI indicate? By the RSI meaning, the indicator compares the size of candlesticks (i.e. the trend strength. The longer is the candlestick, the stronger is the trend) within a particular period specified in the settings. In general, that is what the rsi indicator buy and sell signals are based on.
RSI formula:
Step 1. The relative strength index calculates the range of the positive (U) and the negative (D) change in the price. I will explain the relative strength index formula below.
U = Price(i) - Price(i-1)
D = 0, where
Price(i) is the close price of the current period (i.e. current candlestick), Price(i-1) is the close of the previous period.
U = 0
D = Price(i-1) - Price(i)
If both closing prices are equal, then U = 0, D = 0.
Step 2. Calculation of the relative strength.
RS = SMA(N) of U / SMA(N) of D
The formula means that the values of U and D are smoothed with a Simple Moving Average (SMA) with the N period. One of the sources gives a simplified formula: RS (Relative strength) is the ratio of the average gain to the average loss.
Step 3. Calculation of the RSI indicator
RSI = 100 - ( 100 /( 1 + RS))
This is one of the most common calculation formulas, but not the only one. For example, in adapted versions of the RSI indicator formula, the price change is smoothed using Exponential Moving Averages. The author himself suggested using a Modified Simple Moving SMMA.
Note 1: If you use an SMA in the formula. If the trend is steadily rising, without a single down candlestick for the period written in the indicator settings, the D value in the RS denominator will be 0. Since you cannot divide by 0, the oscillator value is considered to be 100.
Note 2: The above formula describes the general principle of the index calculation, it is not a constant. According to it, when the period is 2 for an uptrend, the index value must be 100. The actual value in the screenshot below is 89.
If you want to explore the formula and understand in more detail, and you know the MGL programming language, you can open the code. In the MT4 menu, enter the File/Open data folder. In the window that opens, go to the directory “MQL4/Indicators”, find there an mql4 file, and run it. It will open in Word.
I have prepared the relative strength Calculator template for technical analysis. The Excel file includes an algorithm for calculating the Relative Strength Index, you can also draw diagrams using the RSI values you enter.
You can download the RSI calculation excel [Sheet here.][2]
You don’t have to set up the standard version; the oscillator is in almost all trading platforms. It is a little more difficult with the modifications. You have to set them up onto the trading platform yourself. Moreover, the indicator code must be compatible with the trading terminal code. For example, for the MT4 platform, it should be the MQL4 programming language. If the trading platform doesn’t suggest adding indicators, you can’t trade with the RSI’s combined versions. If you want to download a modified version, let me know in the comments section. I will write to you where you can get working templates.
Install the Relative Strength Index in the LiteForex trading terminal:
1. In your profile, open the trading chart of any currency pair. For example, [AUD/CAD][3]. Click on the trade TRADE on the left menu, go to the Currencies section, and click on the currency pair you need.
2. At the top of the chart, click on the Indicators tab, and choose the RSI Indicator.
It will appear under the price chart. To see the custom window, click on the corresponding icon (marked with the arrow on the screenshot below).
RSI settings:
1. Parameters:
2. Style:
The LiteForex terminal’s advantage is that you will immediately see any change on the chart next to the settings window. You need to click “OK” or “Apply” to activate other trading platforms’ changes. On the LiteForex platform, you see the customs’ adjustments immediately without unnecessary keystrokes and the need to call the settings window again.
In MT4, you install and configure the Relative Strength Index in a slightly different way from the same procedure for the LiteForex trading terminal, but the general principle is similar.
1. In MT4, you install and configure the indicator in a way that is a little different from the same procedure for the LiteForex trading terminal, but the general principle is similar.
2. Open the custom window:
2.1. Parameters:
2.2. Levels:
You can set the parameters of the level in this tab: the RSI values, the color, and the style of the lines. A good option is setting additional levels using the Add button.
2.3. Visualization:
This tab allows you to set the indicator visualization on all timeframes or some of them.
Drawbacks of the MT4 compared to the LiteForex terminal:
In MT5, the Relative Strength Index is set in the same way as in MT4. You go to the Insert menu and open the Indicators tab. The properties window has a few differences:
To sum up, there are hardly any differences between the MT4 and MT5 platforms concerning the installation and customization of the oscillator.
The most popular RSI trading strategies:
At these moments, the index is in the overbought or oversold zones. If the indicator line goes higher than level 70, you shouldn’t buy the asset.
The strategy implies that you should wait until the index line reverses in the overbought zone and enter a short trade, according to some additional signals. The same is relevant for entering a long trade when the indicator turns in the oversold zone.
Next, I will explain all the above Forex RSI strategies and the signals to buy and sell. I will also give you real-life examples.
Important: The Relative Strength Index indicator features common flaws. The signals are lagging, and the indicator repaints. So, the tool mostly serves as an additional confirming tool to supplement trend indicators, technical patterns, etc. Do not enter trades based only on the oscillator signals.
The RSI indicator well combines with the classical graphical analysis
It is clear from the screenshot that the price lows coincide with the reference points of the price relative strength at the level of 28. Note that the line breaks through the resistance level earlier than the price actually reverses, signaling the breakout in advance. A sell signal is sent when the oscillator breaks out the level built according to the reference points; it is level 28 in our example.
Another example, taken from the MT4. The MT4 chart is sometimes more convenient to study historical data.
The thin red ovals mark the reference points of the indicator coinciding with level 30. When the indicator breaks through level 30, there is a trading signal. It is an early signal. According to graphical analysis, the entry would be at the point marked with the green circle.
Notes on the strategy:
The relative strength index overbought oversold levels are the signal levels, whose default parameters are 30 and 70. When the index line goes beyond these levels, it means that the market is overbought or oversold. When the indicator line reverses in these zones, it could signal the change in the trend direction or a deep correction. However, the trend may go sideways, as in the figures below.
Look for entry points when the lines go back to the range:
With the input parameters (14) for the [EUR/USD][4] pair and the M15 timeframe, four signals appeared.
The first turned out to be weak, although ultimately, the pullback would not have triggered the stop,, and the trade would have yielded a profit. The second one is a perfect trade signal. The third is false. The fourth is true but weak.
Do not strictly follow the default levels parameters of 30 and 70. Use the 5% rule. Find in the daily timeframe the sections where the oscillator’s extreme values for the past three months haven’t lasted more than 5% of the time. Move this level to your trading chart timeframe, revise the level values every 5-10 bars.
Example:
Over the past three months, the indicator hasn’t entered the oversold zone. So, we refer to only the overbought level 76 suits.
We set 76 in the customs and go to the working timeframe. The trades are entered according to the same principle.
The indicator should break through the strong level when it goes outside the overbought oversold zones.
Notes on the strategy:
Divergence occurs when the indicator and the price chart go in opposite directions due to lagging. The Relative Strength Index is a leading indicator, so the price chart is usually lagging. If the price chart continues the trend, and the signal line has reversed, it is divergence. Divergence signals the trend reversal.
Types of divergence:
You can learn more about the divergence in this [overview][5]. Divergence looks like this in the chart:
The signal is the strongest when the divergence occurs while the indicator line is in the overbought/oversold zone. A weaker, but still relevant movement is when at least one of the divergence high/low is above level 70 or below level 30.
The above figure displays the bullish divergence. The levels are drawn across two lows; the indicator line hits one of the lows below level 30. The trend reversed up after the divergence.
Notes on the strategy:
You enter a trade after the price turns in the direction of the indicator line. The entry point in the screenshot is at the bar that is marked by the arrow.
RSI indicator perfectly combines with the Price Action trading strategies. One of the Price Action patterns is a Failure Swing. It is based on the false breakout of a significant High or Low of the previous swing.
When the index is in the overbought/oversold zones, the oscillator line tries to break through the previous high/low. Next, it turns back to the median level. For the RSI overbought zone, the pattern looks like M; it is a W-shaped for the oversold zone.
There is an M-shaped pattern. The indicator line draws the first top in the RSI overbought zone, turns down, and breaks out level 70. Next, it again tries to test the top, but the second high is lower and is not explicit.
Buyers can’t repeat the first high. It is clear not only from the movement of the oscillator line but also from the trend character. The candlesticks’ bodies are getting smaller as the price approaches the peak, drawing a[ Pin Bar pattern][7]. All signals indicate that you can enter a trade at the moment of the trend reversal.
I’ll explain how this method relates to swing trading. I zoom in the chart.
The uptrend’s local high (depicted in the previous figure) is one of the corrections of the price downtrend. The oscillator helps us pick up the moments when the price reverses in the direction of the corrections’ primary trend.
Notes on the strategy:
Andrew Cardwell suggested an rsi trading strategy, different from the approach defined by Wilder. For example, instead of the normal signal levels 30 and 70, he offered to consider the values of 40 and 80 for an uptrend, 20 and 60 for a downtrend separately. He claims that a strong uptrend won’t retrace to the RSI overbought zone, as well as a strong downtrend won’t reach the RSI oversold zone. So, the indicator line should be moving between levels 40 and 60, which serve as support and resistance levels. Cardwell’s trend confirmation is when the price rebounds from these levels.
Trading in the bullish and bearish trend:
As you see from the above figure, the trend is up. The indicator line is most of the time between levels 40 and 80. Both signals at the moment of touching level 40 are strong and true. Note that you should not consider the price rebound from level 80 as a signal to enter a trade in the uptrend.
The market situation displayed in the above screenshot is not that clear. The trend is down, but the price rebounded from level 65 in the second case.
Notes on the strategy:
Positive and negative reversals is another trading approach offered by Cardwell. He noted that the rule of direct divergence is not often observed. For example, a positive reversal occurs when the next low is higher than the low of the previous correction down in the uptrend.
Simultaneously, the next low of the oscillator forms lower than the low of the previous correction. Despite the divergence between the price and the oscillator movements, the price continues running up after a small decline. This situation is called inverse divergence.
For the negative reversal, the situation is the opposite. If the indicator forms a higher high, and the price makes a lower high, the market will continue declining.
Trading the opposite direction:
In the above figure, red lines mark the bearish divergence spotted based on the highs. Green lines mark Cardwell’s positive reversal levels. The divergence drawn across the highs should have signaled a bearish divergence and a soon price reversal down. However, the price continued rising.
Notes on the strategy:
It is related to the stock RSI meaning. The oscillator is used not only to analyze the Forex market and the Forex trading signals. One can also employ stocks Relative Strength Index in the stock market to spot separate securities for short-term investments.
There are thousands of equities traded in the global stock market. One of the ways to select stock for investment is the stock screener.
The stock screener is an analytical platform that provides information on securities. The advantage of screeners is that they offer dozens of filters to sort and group the shares based on any parameter. A screener could be both a website and a part of an analytical information portal.
Read a detailed overview of screeners [here][8].
What does RSI mean in stocks? One of the filter parameters is the data of technical indicators, for example, the RSI stock indicator. Investors should find securities that are currently overbought or oversold and carry out a deeper analysis. You will know if it will be profitable to buy or sell a particular paper.
Examples of screeners:
1. [Investing][9]. It is an analytical portal that has a built-in screener.
There are [amazon][10] shares in the below list. I open the LiteForex trading terminal:
Everything is correct. Thanks to the screener, I didn’t have to revise all the charts of the securities. You can also filter shares by other indicators and criteria.
The disadvantage of Investing is that you can select securities only by the RS index with a period of 14 in the 1D timeframe.
2. [Finviz][11] is another financial analytical portal. It offers more filter parameters. However, the screener analyzes only the US stock market.
Using RSI in Forex trading. As an example, I will take the [EUR/ZAR][12] currency pair in the M5 timeframe. I want to demonstrate to you how to enter a profitable trade, rather than make the maximum profit.
Analyzing the above chart, I see the following:
The price is likely to reverse soon, considering several signals. The resistance level is broken out, the indicator line enters the overbought zone, and there is forming a pattern. We expect the trend reversal and enter a trade when the indicator line breaks out level 30 from below.
Now, the matter is when we should close the position. We could have waited until the index goes up to level 50. We could have also presumed that there is the beginning of the new strong uptrend.
According to Cardwell’s RSI meaning in stocks, the price rise could be a local correction within the ongoing downtrend. So, I do not risk and exit the trade at the first sign of the trend reversal.
I am correct. The trend, following the local correction, has resumed running down. Furthermore, I made a profit on the local correction (marked with the arrow in the screenshot).
RSI trading has yielded a small profit in a short time. This is an example of a scalping strategy.
You can combine the RS oscillator not only with the trend, channel indicators, or graphical analysis but with other oscillators as well. For example, there is the rsi trading strategy Triple confirmation.
It is based on the combination of the RSI, CCI, and stochastic. One enters a trade when the signals of all the three tools coincide. Signals are rare, but the accuracy is more than 80%.
I will sum up in a few paragraphs:
1. Relative Strength Index is a leading indicator measuring the trend strength. It is used to confirm entry signals.
2. The index value changes in the range from 0 to 100. The default signal levels are 30 and 70. The price range between levels 30 and 0 is the oversold zone. The range between 70 and 100 is the RSI overbought zone.
3. The indicator works in any timeframe. The default period is 14. For minute timeframes, you can set a period of 5, 7, 9. For the daily timeframe, the period is 25.
4. The significant signals delivered by the RS index.
5. The values of the signal levels adjusted to each currency pair and timeframe. The settings are:
6. **** You exit trades according to the market situation. You close the position in the following cases:
You can read a detailed overview of how to use your personal profile [here][13]. I’d like to remind you that you still can take part in the [LiteForex dream draw][14]. Register with LiteForex, enter trades, be confident in yourself, and you will succeed. If you still have questions, write them in the comments and I will be glad to answer!
I wish you successful trading!
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The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.
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