What Is RSI FOREX?
The relative strength index, or RSI, is a chart indicator used in technical analysis. Foreign exchange, or Forex, traders often depend on the RSI when making predictions about currency exchange rates. If the RSI provides signals that anticipate a change in these rates, the Forex trader opens a position that would profit from such a change.
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Purpose
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A typical Forex chart provides basic information about how prices change over time. Through the use of complex formulas, it is possible to perform calculations on a set of price data to determine the momentum behind the price changes. The RSI uses a specific formula that looks at many closing prices over a defined period. It charts the outcome of this formula as a sub-graph below the price chart. Reading the RSI is a skill much like reading a regular price chart, and traders learn to compare raw price action to RSI fluctuations when making trading decisions.
Formula
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Before the RSI can run its calculation, you must first specify how much time it should study. A typical RSI indicator is set to 14 periods, but you can customize this in most charting software. This means that the formula will look at the closing prices for the previous 14 bars on the Forex chart. Over this period, you add up all the gains that occur between bars, divide by 14, and then do the same for the losses. You now have the average gain size and average loss size. Divide the average gain by the average loss to determine the "RS" factor. Then, for a given bar, add 1 to the RS and divide 100 by this result. Subtract this new result from 100 and you have RSI value for that bar. All RSI values will fluctuate between zero and 100. While it is useful to know how the formula works, most traders rely on their chart software to compute these values automatically.
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RSI Chart
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For each price bar on the Forex chart, the RSI makes a new calculation. The RSI sub-graph then connects these individual RSI calculations for each bar with a single line. You then have a fluctuation RSI line that accompanies the price action above in the regular price chart. You can make trading decisions of this RSI line itself or compare its movement to that of the price action for other types of signals.
RSI Readings
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If the RSI moves high on its chart, such as above 70, this often indicates an "overbought" situation, and the Forex currency rate may decline after such a reading. Likewise a fall below 30 on the RSI graph can indicate "oversold" conditions before a bounce in prices. Despite the regularity of these patterns, it is possible for the market to remain in an extreme state indefinitely before prices rebound from an RSI overbought or oversold reading.
Divergence
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One of the most effective uses of RSI is to compare the RSI chart to the actual Forex rate chart. If the RSI makes a high that is lower than its previous high but the corresponding exchange rate is instead rising, the RSI is "diverging" from the actual price action. Traders often look for divergences as an early signal for a market reversal. The RSI indicates weakening momentum even as prices move higher. Similarly, a rising RSI while prices fall can indicate a good buying opportunity.
Warning
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Technical indicators can be helpful in analyzing price action, but they are never guaranteed predictors. The RSI can send out many false signals. If you blindly buy into a Forex currency because the RSI drops to a low level, you could be in a losing position indefinitely while the RSI remains in an oversold state and prices decline further. Likewise, the RSI and exchange rate can diverge indefinitely before the actual reversal occurs.
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