What is the “Relative Strength Index” (RSI) and how does it work?

Carolyn Huntington

The Relative Strength Index, also called the RSI Indicator or Relative Strength Indicator, is an oscillating indicator discovered by J. Welles Wilder Jr. in 1978. It compares average price increases with average price losses to pinpoint situations when a product is overbought or oversold. To understand the answer to “What is relative strength index?”, you need to be familiar with the basics.

The Forex market is a highly profitable and high-risk means of making a profit from fluctuations in exchange rates. The tools used to work in the Forex market largely determine the result of foreign exchange trading by Forex market participants, who are clients of brokers. Each Forex broker offers its own trading platform, however, most brokers and traders in the Forex market agree on their choice of MetaTrader 4 and MetaTrader 5 platforms.

As you know, an undertaking on any exchange occurs with the use of commercial orders, which represent a market obligation, the volume of purchased or sold trading instruments for which no offset transactions were made. To “keep” a stable profit, you need to correctly open, close, and modify orders. The essence of profitable trading is simple — buy cheap, sell high and make money on it. For this, the following types of commercial operations are carried out on the exchanges.

Definition of “Relative Strength Index” (RSI) in simple words

The majority of day trading traders do it on Forex. Day trading helps prevent price fluctuations from day to day. It also makes it possible to avoid the night (overnight) charges of certain brokers. Finally, when practiced in the currency market, day trading can also benefit from significant leverage. Thanks to this, the gains can be much greater, just like the losses. The leverage effect should therefore be used with caution. The “Relative Strength Index” (RSI) technique is gaining more and more popularity among traders.

The Relative Strength Index (short: RSI) is one of the standard indicators in every charting tool today, along with many others. The naming of the indicator turned out to be somewhat unfortunate because it suggests a comparison of different underlying values with one another in order to investigate which of the values is the outperformer and which is the underperformer.

Such a statement is not possible with the RSI according to Wilder. Rather, it is a further momentum concept for only one underlying asset. This is because only the strength of price losses in the period set by the trader is compared with the strength of the profits in this period.

In this sense, the RSI rather depicts the inner strength of the underlying asset under consideration and also tries to eliminate some negative aspects of the classic momentum indicator. The latter, on one hand, is relatively susceptible to individual exchange rate extremes and, on the other hand, has an open scale. Above all, this makes it difficult to compare momentum values of different underlying values, and Wilder found the RSI to be a momentum indicator that could solve these problems.

What is oversold

This rather arbitrary term is usually used to refer to a situation when an asset is trading at a price below its real value. This can be the result of negative news or forecasts for a particular company or an entire industry, or, conversely, a general downturn in the market. Sellers open short positions in the hope of making money on falling quotes, while buyers, on the contrary, are active and start pushing the price up. 

A total of three scenarios must be distinguished here. For example, if the signal range is 30/70 and the RSI indicator rises from the 30 range from the bottom to the top, this should serve as a buy signal. However, if there is a downward movement (intersection of the 70 line from top to bottom), this is a sell-signal. If you are a trader who likes a simple and effective strategy, this is the right choice. 

To open an order, too many conditions are not required, but it still gives a high winning percentage. However, the buy signals are often too early, and without a stop loss, this would result in considerable losses in the portfolio. For example, signals from the RSI should not be used exclusively when entering or exiting.

StochRSI (Stochastic RSI) indicator

As any analyst who takes a position with technical analysis knows, the usage of data built on a relative strength index formula normally helps identify areas where the price is too expensive or too cheap. In periods when the indicator is above 80%, it means that the stock is expensive and should be sold, while below 20% it is very cheap and it is appropriate to buy.

This approach provides several advantages:

  • accurate calculations;
  • competent forecasting of the situation;
  • extraction of the established benefit.

The line oscillates between 0 and 100. If the line leaves the extreme range above 70, this is interpreted as an overbought market and thus as a sell signal. If the price movement takes place in the extreme zone below 30, the market is oversold and can be interpreted as a buy signal. These trading signals should still be confirmed by additional methods.

The main reason the RSI is so beloved by novice traders is its simplicity. Any novice speculator will be able to recognize signals for opening deals without any problems. The main signals are the intersection of lines with overbought and oversold zones, as well as divergence, false waves, convergence, etc.

Related information

Also, be sure to remember a simple but effective indicator-based strategy that will help a beginner earn money, so don’t leave. Words with the prefix “re-” often carry a negative connotation, as they mean harmful redundancy. In the language of exchange traders, they are used to determine market conditions that are fraught with trend reversals. To understand the answer to “What is relative strength index?”, you need to study a little more information on this topic. It is generally accepted that in the very fall of the price when the market is oversold, there is already a potential for its rebound and subsequent growth.

At this point, however, we would like to make it clear that the RSI is only an indicator and trading decisions should never be made on the basis of a single indicator. Even if the RSI has a value of over 50, this is not always synonymous with a positive performance of the base value. A sideways movement or even a downward movement can also occur.

Becoming a trader means being an actor in the world of finance. As an intermediary, brokers earn a commission on each transaction. As you can see, if all world transactions have to go through these people, their commissions go over the top. And that’s the case. This is what shaped the image of traders. Everyone thinks of traders as we see them in “The Wolf of Wall Street”, which traces the life of Jordan Belfort, one of America’s most sultry businessmen. Having dealt with the algorithm of this phenomenon, you can easily raise the level of your earnings and bring your profit to a new level.

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