Another indicator developed by J. Welles Wilder, the Relative Strength Index (RSI) is an extremely popular price following oscillator as a measure of a currency pair's price relative to itself and its past performance.
The RSI is fluctuating between 0 to 100, and like all other oscillators, it indicates overbought and oversold readings.
The area above 70 is generally considered to be the overbought region (looking for sell signals), and the region below 30 is referred to as the oversold region (looking for buy signals).
Formula
EMA: An average U is calculated with an exponential moving average using a given N-days smoothing factor
Upday ( today's close higher than yesterday's)
U = close(today) -close(yesterday)
D = 0
Downday ( today's close lower than yesterday's)
U = 0
D = close(yesterday) - close (today)
Recommended period
A smoothing period of n = 14 (standard on most charting software)
Trading signals from RSI
Overbought and oversold signals
Positive and Negative Divergences
Overbought and oversold signals
I. In ranging markets
Wilder recommended using 70 and 30 RSI readings for overbought and oversold levels. Generally, if the RSI rises above 30 it is considered bullish for the underlying currency pair and a trader should look for buying opportunities. Conversely, if the RSI falls below 70, it is a bearish signal for the underlying currency pair a trader should look for selling opportunities.
II. In trending markets
Take only signals from RSI in the main direction of the trend. If the main trend is up, take only oversold signals from RSI. Conversely, if the main trend is down, take only overbought signals from RSI
Some currency traders identify the currency pair's long-term trend and then use extreme readings for entry points. If the mid long-term trend is bearish for a currency pair, then overbought readings could mark potential entry points to go SHORT (again).
Positive and negative divergences signals between price and RSI
Possible buy or sell signals may also be generated when detecting a positive or negative divergence pattern between RSI and the underlying currency pair.
A positive divergence can predict future upturns, while a negative divergence can predict future downturns.
Looking to the above chart, the EUR/USD price is rising while RSI is falling creating a negative divergence, this can can predict a future downturn for the EUR/USD. When divergences occur after an overbought or oversold condition (70 / 30) it usually provide more reliable trading signals.
Please note: When the EUR/USD is falling and the RSI is rising, this will create a positive divergence.
It is recommended to use RSI in conjunction with other technical analysis tools to make a complete forex trading system.
