How To Use Relative Strength Index

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Indicators: Relative Strength Index (RSI)

newdigital, 2013.08.07 12:55

RSI Indicator Forex Trading Strategy

Relative Strength Index or RSI is the most popular indicator used in Forex trading. It is an oscillator indicator which oscillates between 0 -100. The RSI is a trend following indicator. It indicates the strength of the trend, values above 50 indicate a bullish trend while values below 50 indicate bearish Forex trend.

The RSI measures momentum of a currency.

The centerline for the RSI is 50,crossover of the centerline indicate shifts from bullish to bearish and vice versa.

Above 50, the buyers have greater momentum than the sellers and price of a currency will keep going up as long as RSI stays above 50.

Below 50, the sellers have greater momentum than the buyers and price of a currency will keep going downwards as long as RSI stays below 50.

In the example above, when the RSI is below 50, the price kept moving in a downward trend. The price continues to move down as long as RSI was below 50. When the RSI moved above 50 it showed that the momentum had changed from sell to buy and that the downtrend had ended. 

When the RSI moved to above 50 the price started to move upwards and the trend changed from bearish to bullish. The price continued to move upwards and the RSI remained above 50 afterwards.

From the example above, when the trend was bullish sometimes the RSI would turn downwards but it would not go below 50, this shows that these temporary moves are just retracements because during all these time the price trend was generally upwards. As long as RSI does not move to below 50 the trend remains intact. This is the reason the 50 mark is used to demarcate the signal between bullish and bearish. 

The RSI uses 14 day period as the default RSI period, this is the period recommended by J Welles Wilders when he introduced the RSI. Other common periods used by forex trader is the 9 and 25 day moving average.

The RSI period used depends on the time frame you are using, if you are using day time frame the RSI 14 will represent 14 days, while if you use 1 hour the RSI 14 will represent 14 hours. For our example we shall use 14 day moving average, but for your trading you can substitute the day period with the time frame you are trading.

To Calculate RSI:

• The number of days that a currency is up is compared to the number of days that the currency is down in a given time period.
• The numerator in the basic formula is an average of all the sessions that finished with an upward price change.
• The denominator is an average of all the down closes for that period.
• The average for the down days are calculated as absolute numbers.
• The Initial RS is then turned into an oscillator.

Sometimes very large up or down movement in price in a single price period may skew the calculation of the average and produce a false signal in the form of a spike.

Center-line: The center-line for RSI is 50. A value above 50 implies that a currency is in a bullish phase as average gains are greater than average losses. Values below 50 indicate a bearish phase.

Overbought and Oversold Levels:
Wilder set the levels at which currencies are overextended at 70 and 30

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Indicators: Relative Strength Index (RSI)

newdigital, 2013.08.07 13:03

RSI Indicator Overbought and Oversold Levels

RSI values of above 70 are considered to be overbought; traders consider points above the 70 level as market tops and good points for taking profits.

RSI values of below 30 are considered to be oversold; traders consider points below the 30 level as market bottoms and good points for taking profits. 

These levels should be confirmed by center line crossovers. If these regions give a market top or bottom, this signal should be confirmed with a center line crossover. This is because these levels are prone to giving whipsaws in the market.

In the example below, when the RSI hit 70, it showed that the currency was overbought, and this could be considered a signal that the currency could reverse. 

The currency then reversed after a short while and started to move downwards, until it got to the oversold levels. This was considered a market bottom after which the currency started to move upwards again.

Over extended RSI overbought and oversold

When the market is trending strongly upwards or downwards the RSI will stay at these levels for a long time. When this happens these regions cannot be used market tops and bottoms because the RSI will stay at these levels for an extended period of time. This is the reason why we say that RSI overbought and oversold regions are prone to whipsaws and it is best to confirm the signals using center-line crossovers.

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Indicators: Relative Strength Index (RSI)

newdigital, 2013.08.07 13:15

RSI Indicator Divergence Trading Setups

Divergence is one of the trade setups used by Forex traders. It involves looking at a chart and one more indicator. For our example we shall use the RSI indicator.

To spot this setup find two chart points at which price makes a new swing high or a new swing low but the RSI indicator does not, indicating a divergence between price and momentum. 

Example:

In the chart below we identify two chart points, point A and point B (swing highs)

Then using RSI indicator we check the highs made by the RSI, these are the highs that are directly below Chart points A and B. 

We then draw one line on the chart and another line on the RSI indicator.

How to spot divergence

In order to spot divergence we look for the following:

• HH=Higher High- two highs but the last one is higher
• LH= Lower High- two highs but the last one is lower
• HL=Higher Low- two lows but the last one is higher
• LL= Lower Low- two lows but the last one is lower

First let us look at the illustrations of these terms

There are two types of divergence:

1. Classic
2. Hidden

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Indicators: Relative Strength Index (RSI)

newdigital, 2013.08.07 13:34

RSI Classic Bullish and Bearish Divergence Trading Setups

Classic divergence is used as a possible sign for a trend reversal. Classic divergence is used when looking for an area where price could reverse and start going in the opposite direction. For this reason classic divergence is used as a low risk entry method and also as an accurate way of exit out of a trade.

• It is a low risk method to sell near the top or buy near the bottom, this makes the risk on your trades are very small relative to the potential reward.
• It is used to predict the optimum point at which to exit a trade

There are two types:

1. Classic Bullish Divergence
2. Classic Bearish Divergence

Classic Bullish Divergence

Classic bullish divergence occurs when price is making lower lows (LL), but the oscillator is making higher lows (HL).

Classic bullish divergence warns of a possible change in the trend from down to up. This is because even though the price went lower the volume of sellers that pushed the price lower was less as illustrated by the RSI indicator. This indicates underlying weakness of the downward trend.

Classic bearish divergence

Classic bearish divergence occurs when price is making a higher high (HH), but the oscillator is lower high (LH).



Classic bearish divergence warns of a possible change in the trend from up to down. This is because even though the price went higher the volume of buyers that pushed the price higher was less as illustrated by the RSI indicator. This indicates underlying weakness of the upward trend.

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Indicators: Relative Strength Index (RSI)

newdigital, 2013.08.07 14:41

RSI Hidden Bullish and Bearish Divergence Trading Setups

Hidden divergence is used as a possible sign for a trend continuation. Hidden divergence occurs when price retraces to retest a previous high or low.

Hidden RSI Bullish Divergence

Forms when price is making a higher low (HL), but the oscillator is showing a lower low (LL).

Hidden bullish divergence occurs when there is a retracement in an uptrend.

This setup confirms that a retracement move is complete. This divergence indicates underlying strength of an uptrend.

Hidden RSI Bearish Divergence

Forms when price is making a lower high (LH), but the oscillator is showing a higher high (HH).

Hidden bearish divergence occurs when there is a retracement in a downtrend.

This setup confirms that a retracement move is complete. This divergence indicates underlying strength of a downtrend.

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Indicators: Relative Strength Index (RSI)

newdigital, 2013.08.07 14:49

RSI Swing Failure Forex Trading Setup

RSI swing failure can be a very accurate method for trading short term currency moves. It can also be used for trading long term trends but it is best suited for short term trading especially for those traders that trade reversals.

The RSI failure swing is a confirmation of a pending market reversal. This setups a leading breakout signal, it warn that a support or resistance level in the market is going to be penetrated. This setup should occur at values above 70 for an upward trend and values below 30 in a downward trend.

RSI Failure Swing in an upward trend

If the RSI hits 79 then pulls back to 72, then rises to 76 and finally drops to below 72 this is considered a failure swing. Since the 72 level is an RSI support level and it has been penetrated it means that price will and follow and it will penetrate its support level.

In the example below, the RSI hits 73 then pulls back to 56, this is a support level. The RSI then rises to 68 and then drops to below 56, thus breaking the support level. The price then follows afterwards breaking it support level. The RSI swing failure is a leading signal and it is confirmed when price also breaks it support level. Some forex traders open trades once the swing failure is complete while others wait for price confirmation, either way it is for a trader to decide what work best for them.

RSI  Failure Swing in a downward trend

If the RSI hits 20 then pulls back to 28, then falls to 24 and finally penetrates above 28, this is considered a failure swing. Since the 28 level is an RSI resistance level and it has been penetrated it means that price will and follow and it will penetrate its resistance level.

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Indicators: Relative Strength Index (RSI)

newdigital, 2013.08.07 14:59

RSI Indicator Chart Patterns and Trend Lines

Traders can plot trend lines on the RSI in the same way as you can plot trend lines on the price charts. RSI trend lines are plotted the same way trend-lines are plotted on the chart; by joining consecutive highs of the RSI Indicator or consecutive lows on the RSI Indicator.

RSI Chart Patterns

Chart patterns such as head and shoulders or triangle chart patterns that are not evident on the price chart are often formed on the RSI indicator.

RSI indicator also often forms chart patterns such as head and shoulders or triangles patterns that may or may not be visible on the price chart. As shown on the chart below the Reverse Head and Shoulders reversal formation is clearly shown on the RSI indicator.

RSI Support and Resistance Levels

Sometimes levels of support and resistance are demonstrated better on the RSI than on the price chart.

In an uptrend the support levels should not be broken at any one time, if they are broken then price will also break the support levels and the upward trend is going to reverse.

In a downtrend the resistance levels should not be broken, if they are broken then price will also break the resistance levels, and the downward is going to reverse.

In the example above when the third resistance level was broken the downtrend reversed to an upward trend and when the sixth support was broken the uptrend reversed and broke the upward trend line.

Forum on trading, automated trading systems and testing trading strategies

Indicators: Relative Strength Index (RSI)

newdigital, 2013.08.07 15:29

RSI Indicator Forex Trading Strategy Summary

Summary:

The RSI indicator is one of the most widely and commonly used indicators available. RSI indicator is a momentum oscillator with some trend following characteristics.

RSI is one of the most popular indicators used in technical analysis. RSI is used to generate Forex trading signals using crossovers. 

RSI indicator plots the divergence and convergence of moving averages. The RSI is constructed using moving average analysis. Moving Average Convergence/Divergence is a trend-following indicator. It indicates the correlation between two moving averages.