How to Use the RSI Indicator in Trading



Momentum indicators are widely used by forex traders to measure when a market is overbought or oversold. They're often a critical component of forex trading arsenals for traders who live by the old adage, "Buy low, sell high." The Relative Strength Index or RSI indicator is one of the more popular momentum indicators and it's probably among the easiest to use.

RSI Formula

RSI = 100 - 100 (1 + RS),

RS = Average Gain / Average Loss

To simplify the calculation explanation, RSI has been broken down into its basic components: RS, Average Gain, and Average Loss. This RSI calculation is based on 14 periods, which is the default suggested by Wilder in his book. Losses are expressed as positive values, not negative values.

The very first calculations for average gain and average loss are simple 14-period averages:

  • First Average Gain = Sum of Gains over the past 14 periods / 14
  • First Average Loss = Sum of Losses over the past 14 periods / 14

The second, and subsequent, calculations are based on the prior averages and the current gain loss:

  • Average Gain = [(previous Average Gain) x 13 + current Gain] / 14.
  • Average Loss = [(previous Average Loss) x 13 + current Loss] / 14.

Taking the prior value plus the current value is a smoothing technique similar to that used in calculating an exponential moving average. This also means that RSI values become more accurate as the calculation period extends. 

RSI Settings

The default look-back period for RSI is 14, but this can be lowered to increase sensitivity or raised to decrease sensitivity. 10-day RSI is more likely to reach overbought or oversold levels than 20-day RSI. The look-back parameters also depend on an instrument's volatility. 14-day RSI for a volatile currency pair, index or commodity is more likely to become overbought or oversold than 14-day RSI for a less volatile one.

RSI is considered overbought when above 70 and oversold when below 30. These traditional levels can also be adjusted to better fit the security or analytical requirements. Raising overbought to 80 or lowering oversold to 20 will reduce the number of overbought/oversold readings. Short-term traders sometimes use 2-period RSI to look for overbought readings above 80 and oversold readings below 20.

Continue reading for more information or start playing around in a ​risk-free demo account for a better understanding of RSI indicator in real-time.

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Overbought-Oversold

RSI indicator is considered overbought above 70 and oversold below 30. The chart below shows the 14-day RSI. This chart features daily bars in gray with a 1-day SMA in pink to highlight closing prices (as RSI is based on closing prices). Working from left to right, the stock became oversold in late July and found support around 44 (1). Notice that the bottom evolved after the oversold reading. Bottoming can be a process - this stock did not bottom as soon as the oversold reading appeared. From oversold levels, RSI moved above 70 in mid-September to become overbought. Despite this overbought reading, the stock did not decline; instead, it stalled for a couple of weeks and then continued higher. Three more overbought readings occurred before the stock finally peaked in December (2). Momentum oscillators can become overbought (oversold) and remain so in a strong up (down) trend. The first three overbought readings foreshadowed consolidations. The fourth coincided with a significant peak. RSI then moved from overbought to oversold in January. The stock ultimately bottomed around 46 a few weeks later (3); the final bottom did not coincide with the initial oversold reading.

Like many momentum oscillators, overbought and oversold readings for RSI work best when prices move sideways within a range. 

Divergence 

Divergences signal a potential reversal point because directional momentum does not confirm the price. A bullish divergence occurs when the underlying security makes a lower low and RSI forms a higher low. RSI does not confirm the lower low and this shows strengthening momentum. A bearish divergence forms when the security records a higher high and RSI forms a lower high. RSI does not confirm the new high and this shows weakening momentum. Chart 5 below shows a bearish divergence in August-October. The stock moved to new highs in September-October, but RSI formed lower highs for the bearish divergence. The subsequent breakdown in mid-October confirmed weakening momentum.

bullish divergence formed in January-March. The bullish divergence formed with price moving to new lows in March and RSI holding above its prior low. RSI reflected less downside momentum during the February-March decline. The mid-March breakout confirmed improving momentum. Divergences tend to be more robust when they form after an overbought or oversold reading.

Before getting too excited about divergences as great trading signals, it must be noted that divergences are misleading in a strong trend. A strong uptrend can show numerous bearish divergences before a top actually materializes. Conversely, bullish divergences can appear in a strong downtrend - and yet the downtrend continues. Chart below shows the S&P 500 ETF (SPY) with three bearish divergences and a continuing uptrend. These bearish divergences may have warned of a short-term pullback, but there was clearly no major trend reversal.

RSI Swing Rejections Example

Another trading technique examines the RSI's behavior when it is re-emerging from overbought or oversold territory. This signal is called a bullish "swing rejection" and has four parts:

  • RSI falls into oversold territory.
  • RSI crosses back above 30%.
  • RSI forms another dip without crossing back into oversold territory.
  • RSI then breaks its most recent high.

As you can see in the following chart, the RSI indicator was oversold, broke up through 30% and formed the rejection low that triggered the signal when it bounced higher. Using the RSI in this way is very similar to drawing trendlines on a price chart.

Like divergences, there is a bearish version of the swing rejection signal that looks like a mirror image of the bullish version. A bearish swing rejection also has four parts:

  • RSI rises into overbought territory.
  • RSI crosses back below 70%.
  • RSI forms another high without crossing back into overbought territory.
  • RSI then breaks its most recent low.

The following chart illustrates the bearish swing rejection signal. As with most trading strategies, this signal will be most reliable when it conforms to the prevailing long-term trend. Bearish signals in negative trends are less likely to generate a false alarm.

Strategy

A positive reversal forms when RSI forges a lower low and the security forms a higher low. This lower low is not at oversold levels, but usually somewhere between 30 and 50. Chart below shows a stock with a positive reversal forming in June 2009. The price broke resistance a few weeks later and RSI moved above 70. Despite weaker momentum with a lower low in RSI, the stock held above its prior low and showed underlying strength. In essence, price action overruled momentum.

A negative reversal is the opposite of a positive reversal. RSI forms a higher high, but the security forms a lower high. Again, the higher high is usually just below overbought levels in the 50-70 area. The chart below shows price forming a lower high as RSI forms a higher high. Even though RSI forged a new high and momentum was strong, the price action failed to confirm as lower high formed. This negative reversal foreshadowed the big support break in late June and sharp decline.

Setting up the Relative Strength Index (RSI) in MetaTrader 4/5

This section shows you how to set up the RSI in MetaTrader 4/5.

Add the RSI and set the parameters of this indicator

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Setting the common parameters

After you have completed the step above, the settings menu appears.

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Most indicators can be controlled by several common parameters.

There are two types of parameters:

  • Calculations of the indicator: e.g. the amount of periods used for the RSI (you do not need to worry too much about this in the beginning)
  • Visuals of an indicator: e.g. how it will look, the colour and thickness of the lines, etc

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Changing parameters at a later time

To change the settings of the indicator directly on the chart at a later date:

  • Right-click the RSI (you will have to be exact on the line of the indicator to get the menu seen below)
  • Choose RSI(14) Properties – The (14) is the respective parameter (Periods) and can differ, depending on your choice when setting the parameters

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The parameter menu appears again where you can change the indicator.

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Deleting an indicator

To delete the RSI:

  • Right-click the indicator that you want to delete (you will have to be exact on the line of the indicator to get the menu shown below)
  • Click Delete Indicator

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Final Words

Some markets will enter into very strong trends at times without much of a correction. The RSI can stay at overbought or oversold levels for prolonged periods of time. Don't blindly sell overbought markets. Too many traders have been burned to make this mistake.

Most experienced traders will adjust the parameters on the RSI to meet their trading style. Some are short-term traders and they like a fast-moving RSI so they adjust the periods to a lower number like 4. You can also watch different levels for overbought and oversold. 

Understanding how to read the RSI indicator is important, but if you want some help, MetaTrader 5 AM Broker offers a useful RSI toolkit and our trainers can provide you the right guidance. Play around in a ​demo account and notice how the RSI indicator can make you serious money. Alternative, use an Expert Advisor Builder and generate automated trading strategies using RSI accurate settings in a few clicks, without writing codes.

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Categories:  Education