How Strong is the Relative Strength Index (RSI) ?

One of the hardest obstacles to overcome when trading is taking that initial position. You have analysed the market, read a plethora of economic articles, looked at interest rates, economic data, volatility, historical data etc etc. Now you are faced with an “overload” of information. You have the trading strategy in place but when should you buy or sell?

There are numerous indicators that can help you in determining when to “enter” into the market. They should not be used as your sole reason – merely as a confirmation of your idea/trading strategy.

One such indicator that can help confirm when to buy or sell a pair is the RSI; Relative Strength Indicator.

The RSI is, undoubtedly, one of the most popular technical indicators which is calculated on the basis of the velocity and direction of a currency pair’s price movement. This means that the RSI only measures a specific currency pairs strength (based on its past) and should not be confused with its relative strength, that is compared with other currency pairs.

So how does the calculation work?

The RSI is calculated using a two-step process. Firstly, the average gains and losses are identified for a specified time period. Many traders will utilise a 14-day period (any period can be used but the 14-day RSI is the most commonly used). Let’s look at EUR/USD as an example. If EUR/USD went up on nine days and fell on five days then the absolute gains (EUR/USD’s closing price on a given day — closing price on the previous day) on each of these nine days are added up and divided by 14 to get the average gains. In a similar way, the absolute losses on each of the five days are added up and divided by 14 to get the average losses. The ratio between these values (average gains / average losses) is known as relative strength. To make sure that the RSI always moves between 0 and 100, the indicator is normalised later by using this formula:

RSI = 100 – 100 / (1+RS*) * RS = Average gains / Average losses

Overbought/oversold levels.

The RSI value will always move between 0 and 100 (regardless of what period you use); the value will be 0 if the currency pair falls on all 14 days, and 100, if the currency pair moves up on all the days). With this in mind, then the RSI can be used to identify when a currency pair has been overbought or oversold. Therefore most technical analysts consider the RSI value above 70 as being in an ‘overbought zone’ and below 30 as being in an ‘oversold zone’.

Failure swings.

The main problem faced by FX traders who use indicators is that a currency pair may continue to move up despite the indicator hitting the overbought zone, or continue to go down even after the indicator hits the oversold zone. This is the reason the creator of RSI developed a new concept called ‘failure swing’. A ‘bearish failure swing’ occurs when the RSI enters the overbought zone (goes above the 70 level) and comes below 70 again. In other words, a short position can be taken only when the RSI cuts the 70 lines from the top. Similarly, a ‘bullish failure swing’ occurs when the RSI enters the oversold zone and comes out.

Trend direction.

“The trend is your friend” is a cardinal rule of technical analysis and traders can benefit by trading in the direction of the trend. The RSI is also used for determining and confirming the trend.

Lets take a look at some historical data and see if RSI is a good tool to confirm (help you pull the trigger) your trading:

The above chart was taken from MT4 using EUR/USD, H1 on July 24.

A typical candlestick on the top of the chart with an RSI below.

1.The RSI is consolidating around the oversold zone and hugging the 30 line. A break of the line above 30 could be a signal of the market turning bullish. So, upon the break we would buy EUR/USD at, in this example, 1.0817

2.The RSI has stayed in the 33 to 70 range for some time and finally breaks 70 indicating we are entering an overbought zone. When the RSI breaks below 70 this can be an indication that the market is turning bearish and so it is likely to be a good opportunity to sell. Assuming we bought 1 lot at 1.0817 we can now sell 2 lots (taking the profit on our long and opening a short position of 1 lot) at 1.0964

3.The RSI shows a decent sell off and easily breaks 30 into the oversold zone. As in number 1 we are looking for the break upwards of the RSI above 30. When we see the break it is indicating a bullish market so we buy 2 lots (square out our short and go long 1lot) at 1.0871

4.Once again the RSI moves higher with the market and breaks the 70 line indicating, once again, an overbought zone. Once the RSI breaks 70 on the downside we take this as an indication the market is reversing lower so we sell 2 lots at 1.1010. (We cover our long and now go short 1 lot)

5.The market retraces lower and just about breaks the 30 line on our RSI. Again indicating an oversold market. As before we would be looking for the market to move higher if the RSI breaks up through the 30 level – as it does. So we buy back our 1 lot short at 1.0923

So how would we have done in regards to profitability on these trades?

Well, as you can see in this example RSI appears to work!!

That said, the “proof is in the pudding“ so I invite you to conduct your own analysis.