elative Strength Index, or RSI, is one of the most popular technical indicators, which has also proved its efficiency with fundamental analysis.
It was developed by a technical analyst named J. Welles Wilder.
Its basic function is to help traders to evaluate the strength of the current market.
RSI is similar to Stochastic as it displays overbought and oversold conditions in the market.
It is extremely popular among traders, as it has many applications and benefits:
- It can be used on any financial instruments and time frames
- Help identify price reversal points
- Reports levels of overbought/oversold
- It can form graphic patterns that are difficult to see on the price chart
- Can be used to confirm price models
- Very easy to use and does not burden the chart
On the other hand, the RSI indicator has its weaknesses:
- It is a leading indicator, which means that his signals speed up
- It tends to generate more false alarms in the event of sudden price changes
RSI is scaled from 0 to 100.
Readings of 30 or lower indicate oversold market conditions and an increase in the possibility of price strengthening (going up), which could indicate that it is a good time to go long.
Readings of 70 or higher indicate overbought conditions and an increase in the possibility of price weakening (going down), which reveals that a reversal is coming and it is time to go short.
There is one big benefit of using the Relative Strength Index (RSI) indicator, except identifying the overbought and oversold conditions, it also can show centerline crossovers.
If there is a movement coming from below centerline (50) to above, it is an indication of a rising trend.
A rising centerline crossover is:
When the RSI value crosses ABOVE the 50 lines on the scale, moving towards the 70 lines, the market trend is increasing in strength, and it could be considered a bullish signal until the RSI approaches the 70 lines.
If there is a movement from above the centerline (50) to below, it is an indication of a falling trend.
A falling centerline crossover is:
When the RSI value crosses BELOW the 50 lines on the scale, moving towards the 30 lines, then the market trend is weakening in strength, and it would be considered as a bearish signal until the RSI approaches the 30 lines.
How to Trade Using RSI
Exactly like the Stochastic indicator, it can be used to show the potential tops and bottoms, based on the market overbought or oversold conditions.
You will see below a 4-hour chart of EUR/USD, which is in a downtrend.
EUR/USD had fallen approximately 400 pips over the course of two weeks.
On June 7, it was already trading below 1.2000.
When the RSI dropped below 30, it gave an indication that the trend might be over.
As it follows, the price reversed and went back up over the next couple of weeks.
Determining the Trend using RSI
Another useful side of this indicator is that it can be applied to give a confirmation for trend formations.
If the RSI is above 50, then a possible UPTREND might be forming.
If the RSI is below 50, then a possible DOWNTREND might be forming.
You can see that at first, a possible downtrend was forming.
If you are not sure, it is better to wait for RSI to go below 50, in order to confirm the trend and avoid fakeouts.
Did you already choose which technical indicator is your favourite one?
Even if you did choose, wait to see the next ones, there are some exciting ones coming.