The American investor and technical analyst, J.Welles Wilder, is the developer of the popular RSI indicator. Beside the RSI, Wilder created also the Average True Range (ATR), Average Directional Index (ADX), and Parabolic SAR. In this article, an explanation of the Relative Strength Index will be presented, together with real-life examples on the currency market.
Although the RSI was featured in Wilder’s book „New Concepts in Technical Trading Systems“ in 1978, it is still widely used today. The RSI is, just like the MACD or Stochastics, a momentum oscillator, and requires therefore additional confirmation for opening buy and sell positions.
The relative strength index measures the size of recent gains and losses for a specified time period, and also includes the speed of these price movements in its calculation. Due to these characteristics, it is primarily used for identifying overbought and oversold situations in a financial instrument.
The standard setting used with RSI is a 14-day period. This is recommended by Wilder himself. If the average gains are larger than the average losses during a particular period, the RSI will have a higher value. And if average gains are smaller than average losses, RSI will move downwards. Like all trading topics, a chart is the best description. Let’s look at the USD/JPY chart with an RSI indicator included (red).
An Introduction to the RSI Indicator
It is also possible to use the RSI with time frames other than the daily, but in this case special attention is needed as the RSI can become more volatile on shorter timeframes, thus creating more false signals. The RSI indicator has a normalized value in the range from 0 to 100. This means, if over the periods indicated in the settings the price moved only up, the RSI would have a value of 100. It the price moved only down, the RSI would be 0. The RSI is a very effective indicator in creating trading signals, which only added to its popularity. The most popular use of RSI includes identifying overbought/oversold areas.
Overbought and oversold areas
The RSI is widely recognized to have the ability of identifying overbought and oversold situations in a currency pair. Usually if the RSI is under 30, it indicates that the pair is oversold, while a value over 70 indicates an overbought area. With a strong upward move in the price, the RSI will get a higher value. If the price moved too quickly and the RSI is above 70, the presumption is that a correction move is ahead and traders should prepare for a fall in the price. This is considered an overbought situation.
Similarly, if the price moved quickly downwards and the RSI is below 30, traders should expect a possible upward move and prepare accordingly. This is an oversold situation. A popular trading strategy regarding overbought and oversold conditions, is letting the RSI move below 30 and waiting to break above 30 again, for opening a long position in oversold conditions. Letting the RSI move above 70 and waiting to break below 70 again would be used as a signal for entering a short position in overbought market conditions. The RSI can stay in oversold and overbought areas for a long time during strong down- and uptrends, and utilizing this strategy avoids entering counter positions in these situations.
Like all momentum indicators, the RSI can also produce false signals from time to time, especially during strong trends or on lower timeframes. Traders should therefore use other confirmation signals as well, and not solely rely on technical momentum indicators.
Trading the RSI Indicator on USDJPY
In the chart above, the first two red arrows show the RSI making false sell signals, while the price is still in an uptrend. The next three red arrows show that the RSI went above 70 and then moved back below 70, creating sell signals which resulted in nice drops of the price as the chart shows. The last green arrow follows the rule for opening a buy position in oversold conditions. The RSI went below 30 and came back above 30, which sends the signal of opening a buy position. As the chart shows, this would also result in a profitable position as the price moved up. Stop-loss orders should in both cases be placed just above/below previous swing highs/lows.
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