Relative Strength Index

The Relative Strength Index – known as the RSI – is an index used to show the momentum of directional price movements of financial instruments. Momentum in this context is essentially the speed at which the price is rising and falling. The RSI is what is known as a momentum oscillator, and is a technical indicator that is used in the technical analysis of certain markets – such as the Forex market. The Relative Strength Index was published in the book from the 1970’s, “New Concepts in Technical Trading Systems”, having been developed by J. Welles Wilder. It is one of the most widely used momentum oscillators and popular among Forex Traders.

Calculating the Relative Strength Index

The RSI is generally used on periods of 14 days, and compares the average of up and down closes during that time frame. It can also be applied to longer and shorter periods of time. To calculate the Relative Strength Index of any financial instrument, you need to look at the price activity of that financial instrument and work out the number of “gain days” (where the price has risen through the course of a trading day, also known as “up closes”) and the number of “loss days” (where the price has fallen through the course of trading day, also known as “down closes”).

Once you have determined the number of up days and the number of down days, you must then work out the average gains during gain days and the average losses during loss days. If, for example, there had been 10 gain days and five of those gain days saw a price movement of +2, and the other five of those gain days saw a price movement of +1, then the average gains would be 1.5. This is calculated by adding the total gains during the gain days, and dividing by the number of gain days. The principle for calculating average losses during loss days is the same; total losses during the loss days, dividing by the number of loss days. For the sake of this calculation, average gains during gain days is “g”, average losses during loss days is “l”.

The calculation for the RSI is then RSI = 100 – 100 / ( 1 + RS ) where RS is equal to g / l. So, if g = 1 and l = 2, then the RSI would be 33.33. The RSI will always range from 0 to 100.

Using the Relative Strength Index in Forex Trading

The Relative Strength Index is essentially used in Forex trading to help determine whether a particular foreign currency is being overbought or oversold. Where the RSI is 70 or greater, the indication is that the currency is overbought, suggesting that prices may have risen further than market expectations. This could mean the currency is becoming overvalued and is likely to experience a drop in price. Where the RSI is 30 or below, the indication is that the currency is oversold, suggesting that prices may have fallen further than market expectations. This could mean the currency is becoming undervalued and is likely to experience an increase in price.

It should be noted that the RSI is not always an entirely accurate indicator of where an instrument has been overbought or oversold, as large price increases or price falls can affect the RSI and create false indications. The RSI should not, by itself, be used as a buy or sell signal; rather it should be used in conjunction with other indicators, strategies and tools to help make decisions. In particular, the RSI can be a very useful tool to confirm – or otherwise – a trend formation. For example, if you have highlighted a situation where you believe an uptrend is forming, then you would expect the RSI to be above 50, to confirm the trend. If you believe there is a downtrend forming, then you would expect the RSI to be below 50.

Summary

The Relative Strength Index is a popular index that is commonly used by Forex traders. It is very important not to use the RSI as a standalone indicator of buy and sell signals, but it can be very useful when used to complement other methods. The default period of 14 days can be adjusted to suit your own needs, noting that while the longer period used, the less chance of a false signal, the shorter the period the greater the chance of gaining an edge in identifying notable turning points in a market.