The Relative Strength Index (RSI) is a technical indicator that assesses the strength or weakness of a currency pair by comparing its upward movements to its downward movements over a specified time frame. It tracks recent price gains and losses and relates them to the current price.

Developed by J. Welles Wilder Jr., the RSI first appeared in his 1978 book, “New Concepts in Technical Trading Systems.” The RSI is classified as a momentum indicator, which means it helps determine the speed and strength of price movements, indicating whether the underlying momentum is increasing or decreasing.

In addition to assisting traders in identifying price momentum, the RSI is also utilized to spot overbought and oversold conditions, as well as divergence and hidden divergence signals.

The RSI is represented as an oscillator (a line graph that fluctuates between two extremes) and varies between 0 and 100. On a price chart, the RSI is depicted as a single line calculated by combining the following data over a specified period:

• The average gain during price increases within a set time frame.
• The average loss during price declines within a set time frame.

A ratio of these two values creates a measure that ranges from 0 to 100. Readings above 50 indicate a generally rising price movement, while readings below 50 suggest a generally falling price movement.

“Oversold” vs. “Overbought”

The RSI is deemed “oversold” when it falls below 30 and “overbought” when it exceeds 70, leading to three primary “areas” to consider:

• 0-30: Oversold (OS) area
• 30-70: Neutral area
• 70-100: Overbought (OB) area

Uptrend vs. Downtrend

In an uptrend or bull market, the RSI typically remains in the 40-90 range, with the 40-50 zone serving as support. Conversely, in a downtrend or bear market, the RSI usually stays in the 10-60 range, with the 50-60 zone acting as resistance.

Default Settings

The default period setting for the Relative Strength Index (RSI) is 14 periods. Traders may use different values, generally ranging from as low as 2 periods (for weekly charts) to as high as 25 periods (for shorter timeframes).

The Relative Strength Index (RSI) can be beneficial in various ways. It can be used:

• To confirm a new trend.
• To indicate when a recent price movement may be reaching “overbought” or “oversold” levels.
• To signal a potential price reversal due to divergence between the actual price and the RSI indicator.

Let’s explore the different methods of using RSI to generate trading signals.

Overbought/Oversold (Trend Reversal)

As the price declines, the RSI approaches 0. Conversely, as the price increases, the RSI approaches 100. The more extreme the values, the more “overbought” or “oversold” the currency pair is perceived to be.

The upper range above 70 indicates overbought conditions, while the lower range below 30 indicates oversold conditions. An overbought signal suggests that the recent price rally may be concluding (at least temporarily) and that the price might soon decrease. An oversold signal indicates that the recent price drop may be ending (at least temporarily) and that the price might soon recover.

Convergence/Divergence (Trend Strength/Weakness)

Convergence occurs when the RSI moves in the same direction as the price, signaling potential trend strength and increasing bullish momentum. Divergence happens when the RSI moves in the opposite direction of the price, indicating potential trend weakness and decreasing bullish momentum.

When the RSI reaches an overbought or oversold level, it should be viewed as a warning that the current trend may soon lose momentum. However, just because the RSI enters an overbought or oversold level does not guarantee a trend reversal; it merely indicates that the possibility exists.

BUY Signals

• Oversold signal (Trend Reversal): A buy signal occurs when the RSI drops to an oversold level (30 or below) and then rises back above 30.
• Uptrend alert (Trend Confirmation): A buy signal occurs when the RSI, previously below 50, rises back above 50.
• Bullish Divergence signal (Trend Reversal): A buy signal occurs when a bullish divergence forms between the price chart and the RSI indicator, characterized by the RSI making a higher low while the price makes a lower low.

SELL Signals

• Overbought signal (Trend Reversal): A sell signal occurs when the RSI rises to an overbought level (70 or above) and then falls back below 70.
• Downtrend alert (Trend Confirmation): A sell signal occurs when the RSI, previously above 50, falls back below 50.
• Bearish Divergence signal (Trend Reversal): A sell signal occurs when a bearish divergence forms between the price chart and the RSI indicator, characterized by the RSI making a lower high while the price makes a higher high.

Calculating the RSI involves a multi-step process that measures relative strength by comparing average periodic gains and losses. This is done as follows:

• Average Gain: A gain is a positive change in periodic closing prices. To calculate the average gain, sum all periodic gains and divide by the period (Total Gain / Period).
• Average Loss: A loss is a negative change in periodic closing prices. To calculate the average loss, sum all periodic losses and divide by the period (Total Losses / Period).
• Relative Strength (RS): Relative Strength is calculated by dividing the average gain by the average loss (Average Gain / Average Loss).

Let’s examine the RSI formula using the default 14-period setting:

RSI = (100 – (100 / (1 + RS)))

In this formula, RS stands for “Relative Strength.” Next, we need to calculate the value of the Relative Strength (RS):

RS = (14 EMA on the last 14 up bars) / (14 EMA on the last 14 down bars)

Once you determine the value of RS, you can apply it in the initial formula to obtain the current RSI value.