The relative Strength Index is a trading indicator that is very popular among forex traders. It is mainly used for analysing the market. They help you to determine the entry and exit point to make a significant profit.
If you don’t know about the RSI index, this article is very beneficial for you. Here you can check what the Relative strength indicator is and how it works. Before talking about the calculator, we will explain what RSI is and how to analyse the RSI chart.
What is the Relative Strength Indicator?
J.Welles Wilder developed the Relative Strength Index in the 70s. It is a trading indicator, a momentum oscillator that helps measure the rate of change of down days and boost up days. In simple words, it is an indicator that is used to determine changes in the price movement and speed.
The RSI provides a result in a value that fluctuates between 0 -100. If the value represents a higher number will be considered overbought, Whereas a low value represents oversold. If the value indicates more than 70 by an indicator, the indicators show the overbought, whereas if it is indicating less and equal to 30, it will be considered an oversold market.
Overbought and oversold are the terms used to define the moment of the marker when it will rise and will revert soon; this phenomenon is known as mean reversion. It is very common in equities; however, it may also appear in many other markets.
Suppose the indicator shows that the market is oversold, which indicates that the market is going to drop. On the other hand, overbought will indicate the alternative of oversold. Traders must note that the Relative Strength Index will work for mean reversal as well as for momentum trading.
How to calculate Relative Strength Index?
It will compare two different measurements for providing results. Check here the measurement criteria for the RSI indicator.
- The price gain on rising days should be considered first. The rising day/Up days are considered days when the market closes at higher prices than the previous days.
- The price loss or down days should be considered the second measurement. Down days are considered days when the market closes at lower prices than the previous days.
The RSI indicator compared the measurement of these two categories for calculating the RSI.
RSI indicator = 100 – [100 / 1 + RS]
In the Relative Strength Index formula,
Relative strength is the average gain over x periods / average losses over x periods.
Generally, the RSI is a calculation of the excellent price closes compared to unprofitable price closes, shown as a percentage. When the values are shown as percentages, the indicator will fluctuate between 0 to 100.
How does the RSI indicator work?
As we mentioned before, the RSI indicator provides an indication of overbought and Oversold. If the indicator is showing the measurement above or equal to 70, it will be considered overbought. On the other hand, if it is showing equal to below 30, then it may be considered oversold.
Traders can also rearrange these measurements if they think increment or decrement in these values is necessary for betterment. For instance, If the price of assets is continuously reaching 70, you can easily adjust this level to 80.
Investors must be careful at the time of solid trends because, during this, the RSI may be stuck in overbought and oversold for a more extended time period.
Relative strength Index always creates chart patterns that should not indicate over the major price charts like trend lines and double bottoms and tops. Traders can also check support and resistance on the RSI chart.
During a bull market or an uptrend, the RSI indicator fluctuates between the 40 to 90 range along with the 40 to 50 zone playing the role of support. On the other hand, in the situation of a bear market or the downtrend, the RSI chart will show results between the 10 to 60 range along with the 50 to 60 zone playing a role of resistance.
The range is totally dependent on the RSI indicator’s settings and the market’s underlying trend or the ability of the assets. One must note that if the fundamental assets generate new lows or highs, which is not confirmed by the RSI, This divergence will indicate a price reversal.
Suppose the indicator generates a lower high and then tracks a downwards trend below a previous low; in this case, top swing Failure has taken place. Whereas the indicator generates a higher low and then tracks the upside move above the previous one. This means a bottom swing failure has taken place.
RSI Momentum Indicator
Few markets do not work too effectively with the fundamental reversion strategies, while they are not reverting by nature. Although, It does not mean that you can not use the Relative Strength Index for that specific market.
It is all about that we need to think quite differently, and you need to apply logic differently. This means, in place of purchasing at low costs, you have to buy at high prices.
Different types of RSI Trading Strategies
Now we talk about a few rsi trading strategies that work efficiently. Although, you can use these strategies to earn profit in the market. Check here some highly efficient RSI trading strategies.
Buy Low Sell High
It is the trading strategy that demonstrates online, and it has few advantages. It allows us to perform trade by ourselves. The principle of using this strategy is simply such that you need to enter the market when the RSI indicator is indicating below 30, whereas you can exit when it indicates above 70.
For this, you need to wait for the market pullback condition and, after that, purchase it again in anticipation of an upcoming correction, and This will provide a new high to your securities. Check here for an example of trading in which this strategy is applied.
The yellow ring appears to indicate the entry point, and after that, you need to wait till the Relative strength index rises above 70, which indicates the exit point. If you can see in the picture, you will notice the market has moved a little bit up to exit the strategy.
Due to this small hike, only a few traders will sell their security, and others will keep hoping for a significant increase. For instance, as we mentioned before, you can set a range as per the market here 50 is a better selling range than 70. Therefore, if traders estimate the better range, they will end up with a high number of successful trades.
Alternatively, you can also reset their lower range according to the market, which helps you to make significant profits with better trade numbers.
The RSI indicator also helps you to determine the market strength that is really acting on. The prime aim of this indicator is to identify those points when the market will perform strongly for continuously moving in the direction of price momentum.
For that, you need to identify the breakout in the RSI chart indicator. Suppose RSI breaks toward the upside, and we continuously track it by moving along with it. Suppose if the opposite of this will take place. In that condition, we will go short.
In a few markets, this strategy works more efficiently compared to the traditional one, which is a mean-reverting approach. All these should take place with the classification of the market if you.
For example, if you are trading in the stock market, it will be highly simple for you to determine the mean reversion system which performs well compared to the trend following. Oppositely, if you are going to trade in other markets, such as the energy market, the trend-following/ momentum approach will work better for you.
For the Relative Strength Index breakout, the best setting criteria generally comes around 2-7. You can also apply this setting for RSI breakout.
While using breakout level, you can consider any of the given approaches.
- For determining the breakout level, you can utilise previous lows and highs in the RSI indicator.
- Utilise a stable breakout level like 20 for short and 80 for long.
Check more about these approaches in the upcoming paragraph.
Utilise the past RSI low and high
By using this approach, you can check at the past highs and lows in the RSI to determine the correct point where the security. Suppose breaking the level will move forwards in the short term trend direction.
For instance, RSI is indicating reversal at 80, and we need to tack RSI break 80 for holding a position for the long term. Alternatively, in case RSI is indicating upside reversal at 20, you need to track the 20 levels, and you need to go short during RSI crossing 20.
Generally, we are utilising the principle of resistance and support, but we are using the RSI in place of the price charts. The reality is the breakout move in that direction based on the past lows and high points which means the breakout level is powerful.
This is totally different from the fixed breakout level, where we think that the breakout levels are stable. Some leading brokers who provide a wide range of technical analysis tools to their clients is 101investing.
Applying a Fixed Breakout Level
The fixed breakout approach is far better than the previous high and lows. In this approach, you may not require to track RSI lows and highs; we only need to set a breakout level before entering into a trade.
Here we example this approach with the example in which we previously set the ranges.
- 80 for moving long
- 80 for moving short
As fast as the Relative Strength Index shows that the ring is moving below the 20, you can short the market whereas, if it goes above the 80, you can easily move long in the market. You can see this in the RSI chart given below.
Now you may not be required to track account prices that are appropriate for keeping the breakout level. Therefore, it is a little complicated to understand. But it will perform better comprised to applying forcefully adjusting breakout levels.
How to determine the Exit point?
There are two exit options are available that you can be considered are:
- You can exit a trade when the RSI starts retracing the whole breakout level again. Suppose you enter at 80; you may be required to exit while the RSI passes below the 80 again.
- You can also determine exit points by utilising a stop loss and profit target. In both of them, which one reaches its level first will be your exit point.
It is one of the efficient principles of trading. It indicates while two data sections are moving in a particular direction, they diverge or converge. In this, the Relative strength Index starts moving in an alternative direction compared to the price.
Generally, divergences are classified into two categories based on in which direction they appear. The two categories are:
- Bullish Divergences
- Bearish Divergences
A bullish divergence refers to the price which generates newer lower lows when the RSI generates a newer, higher low. It is an indicator that the strength and speed of the downturn are decreasing. However, bullish divergences are efficient and a particular reversal of the trend towards the upside.
Now we reach the end of the article, where we can conclude that Relative strength Index indicators are effective for determining entry and exit points of a trade. Here we provide you with complete information about RSI indicators in this article. Learn how they work and how you can calculate market strength through them. Read this article to collect a study about RSI charts and trading strategies. Find tools available for RSI by reading PrimeFin review.