What is Relative Strength Index?

Relative Strength Index (RSI) helps traders understand how frequently the currency pair prices change in the forex market to predict the future market prices. RSI also tells traders where exactly the market can potentially retrace, providing them with the ideal entry and exit price levels. Let's take a look at everything you should know about Relative Strength Index (RSI)

Understanding Relative Strength Index?

Relative Strength Index is a technical indicator that helps in analysing the current and historical market strength based on the closing prices of currency pairs. It measures how much a currency pair's prices fluctuate to identify temporary overbought and oversold market conditions. RSI oscillates between numbers 0 to 100. Whenever RSI crosses above 70, it indicates an overbought market situation signaling downward retracement. However, when the RSI readings fall below 30, it indicates an oversold market situation signaling upward retracement.

How does the Relative Strength Index work?

• The Relative Strength Index fluctuates between 40 to 90 levels in a bullish market, where the 40-50 level acts as a support zone. At this support level, the falling prices stop falling and start increasing instead
• The Relative Strength Index fluctuates between 10 to 60 levels in a bearish market, where the 50-60 level acts as the resistance zone. At the resistance level, the rising prices stop rising and start decreasing instead
• A price reversal takes place if the currency pair prices reach a new high or low point that the Relative Strength Index does not confirm. This means, if the currency pair price makes a new high but sudden fall or makes a new low followed by an uptrend, a market failure takes place where the price trend changes direction.

Relative Strength Index can be calculated with the following formula

RSI = 100 – [100 / {1 + (average of the upward price change/average of the downward price change)}] The Relative Strength Index can be calculated for any time period, but the standard suggests using 14 periods to calculate the first RSI value as it provides traders with a more substantial market momentum that has been existing for some time now.

What are the two types of Relative Strength Index?

1.Swing Rejection

Swing Rejections occur when the market is reemerging or changing direction from its oversold or overbought territory to its actual direction. They can be either bullish or bearish. Bullish Swing Rejection or failure swing bottom takes place right after a currency pair price marks a new lower low price with RSI making a higher low price, rising above the latest high price level. For example, if you are trading USD/EUR at 2, and the price increases to 2.5 with RSI also increasing from an oversold situation to a normalised position at 40, the market will change its direction and start increasing due to the bullish swing rejection taking place. It signals traders to enter the market and purchase more of the currency pairs due to the anticipated upward market reversal. Here is how a bullish Swing Rejection takes place:

• RSI first falls into the oversold zone
• RSI crosses above the 30 level
• RSI witnesses another dip but does not cross into the oversold zone again
• RSI finally breaks into its recent high

In case of a bearish Swing Rejection, where the currency pair price reaches a higher high with the Relative Strength Index reaching a lower high falling below its recent low, the traders are signaled to exit the market and sell their trades due to the anticipated downward market reversal. Here is how a bearish Swing Rejection takes place –

• RSI first increases to reach the overbought zone
• It crosses below the 70 point
• RSI again witnesses another high but does not cross back into the overbought zone again
• RSI finally breaks into its recent low

For example, if you are trading USD/EUR at 2, and the price falls to 1.5 with RSI also falling from an overbought situation to a normalised position at 47, the market will change its direction and start falling due to the swing rejection taking place.

2. Divergence

Relative Strength Index Divergence refers to the price level where the currency pair prices move in the opposite direction to its RSI. This means, when the prices make higher highs or lower lows, RSI makes lower highs or higher lows, signalling divergence in the indicator. A bullish Relative Strength Index Divergence occurs when there is an oversold market situation, followed by higher lows matching lower lows of the currency pair’s price. It indicates a continued bullish momentum that breaks above the oversold zone, triggering long positions in the market. A bearish Relative Strength Index Divergence occurs when there is an overbought situation in the market, which is followed by lower highs matching higher highs of the currency pair’s price. It indicates a continued bearish momentum that breaks below the overbought zone, triggering short positions in the market.

Benefits of Relative Strength Index

Identifies advance breakouts and breakdowns

Breakout refers to strong bullish/upside moves, and breakdowns refer to strong bearish/downside moves. As soon as the Relative Strength Index breaks the previous top before the currency pair price is able to cross it, there is an advance breakout in the market. The early signal indicates that the currency pair price will also follow RSI in the near future, signaling traders to enter the market to open buy positions. In advanced breakdowns, Relative Strength Index breaches below the last bottom, and the price remains below or at the recent low. This situation indicates that the currency pair prices will soon break the previous low and follow RSI indicator, signaling traders to exit the market by selling the existing currency pairs.

Indicates failure swings

Failure swings are a point where the Relative Strength Index diverges from the currency pair price line, indicating a declining trend in the overbought or oversold market momentum. A bullish failure swing occurs as soon as RSI falls below 30 in an oversold situation, followed by an immediate bounce back breaking the initial high price level. This sends traders a buy or long signal.

On the other hand, a bearish failure swing is when the Relative Strength Index crosses the 70 points, bounces back, and remains below 70 to break the intimal low price level. This sends traders a sell or short signal.

Determines pattern breakouts

Pattern breakouts occur whenever the currency pair prices move beyond the resistance level or below the support level. It indicates a potential price trend in the breakout's direction. This means an upside breakout leads to the price trending higher, and a downside breakout leads to the price trending lower. When combined with the Relative Strength Index indicator, price patterns can witness a pattern breakout wherever RSI line breaches its 70 or 30 levels.

• When Relative Strength Index breaks above the 70 levels, the patterns indicate prices trending in the upward direction
• When Relative Strength Index breaks below the 30 levels, the patterns indicate prices trending in the downward direction

Indicates market price directions

The Relative Strength Index consists of a mid-50 line that helps indicate the forex market price movement. In a bullish market, prices are always above the mid-50 line, and prices are always below the mid-50 line in a bearish market. This Relative Strength Index mid-50 line acts as a trend changer because any price movement above or below this line indicates stronger market momentum.

• Relative Strength Index above the 50-line is considered as an uptrend
• Relative Strength Index below the 50-line is considered as a downtrend

Top Five Relative Strength Trading Strategies

1. Candlestick Divergence Pattern Strategy

Candlestick patterns work together with the Relative Strength Index to help analyze where the market can potentially reverse, which also helps you identify ideal entry and exit points. When RSI readings coincide with the candlestick pattern, it confirms short and long entry positions in the market.

• Relative Strength Index signals traders to enter short positions if there is a bearish candlestick pattern
• Relative Strength Index signals traders to enter long positions if there is a bullish candlestick pattern

2. Two-period RSI Strategy

The Two-period RSI strategy provides traders with short-term entry and exit signals. When the Two-period RSI falls under 10, it signals traders to enter buy positions as the market is considered to be oversold, and there is a potential uptrend expected. When the Two-period RSI moves beyond 90, it signals traders to enter sell positions as the market is considered overbought, and a potential downturn is expected.

3. RSI Moving Average Crossover Strategy

In this strategy, the Relative Strength Index is combined with the moving average crossover. You need to consider a slow-moving average like the 4-period average and a long-moving average like the 13-period average. The currency pairs are bought or sold when RSI overbought or oversold signals are matched with the moving average crossover.

• When the Relative Strength Index enters a temporary oversold area and exits it soon enough, it generates a buy signal. At the same time period, the moving averages witness a bullish crossover, giving traders another buy signal confirming the trend since the two signals match.
• When the Relative Strength Index enters a temporary overbought area and exits it soon enough, it generates a sell signal. The moving averages witness a bearish crossover in the same period, giving traders another sell signal confirming the trend since the two signals match.

4. Parabolic Stop and Reverse (SAR) RSI Strategy

Parabolic SAR helps traders identify potential reversals in the forex market. It appears on the chart as dots,sending buy signals whenever the dots in the chart move below the currency pair price and sell signals whenever the dots move above the prices. Combined with the Relative Strength Index trading strategy, it confirms buy and sell signals.

• Whenever the Parabolic SAR’s first dot is below the currency pair’s price, and Relative Strength Index falls below 30, traders receive a buy signal to enter the market
• Whenever the parabolic SAR’s first dot is above the currency pair’s price and Relative Strength Index moves beyond 70, traders receive a sell signal to exit the market

5. Support and Resistance RSI Strategy

Combining the support and resistance levels with the Relative Strength Index helps traders confirm oversold and overbought zones in a market. Support levels are prices beyond which the market does not fall, and resistance levels are prices beyond which a market does not increase.

• If the support is at the 50 levels at max and Relative Strength Index is fluctuating between 40-90, it sends traders a buy signal since the market is in an uptrend
• If the resistance is at the 60 levels at max and Relative Strength Index is fluctuating between 10-60, it sends traders a sell signal since the market is in a downtrend
• Relative Strength Index dipping below 70 to 80 levels will become a bearish indicator
• Relative Strength Index exceeding 20 to 30 levels will become a bullish indicator

Trade the forex market with the Relative Strength Index

The Relative Strength Index helps traders identify strong buy and sell signals in the market by comparing the RSI trend line with the market levels. It can be combined with several other strategies like MA crossover, Parabolic SAR, and more to confirm the market signals.

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