Table of Contents
RSI – Relative Strength Index
The RSI indicator is very popular among traders and investors in all financial markets and has been discussed in several books, articles, and conferences over the past years.Wilder, the main developer of the RSI indicator, has explained this indicator and its applications in a book that he published in 1978, “New Concepts in Technical Trading Systems.” Although this indicator had been invented before the computer age, it has proven its reliability in analyzing financial markets.In this RSI indicator tutorial, RSI indicator applications are discussed for signal generating in Forex and other financial markets.
What is The RSI Indicator
J. Welles Wilder first established the relative Strength Index (RSI) indicator. This indicator is a momentum oscillator (an exponential oscillator that shows the strength of the market) and is used to calculate the speed and direction of price variations in the market. RSI oscillates between 0 and 100. Conventionally, levels 30 and 70 show the overbought and oversold levels, respectively.
However, divergences, failure swings, and the median level could also be used to analyze the market. Additionally, RSI is used to indicate the market’s trend. Generally, the RSI indicator is a reversing indicator and is mostly used to specify the reversal points in the market.
It shall be noted that the recommended period for RSI is the 14 candle period. It makes no difference whether you use a daily or hourly time frame. The most suitable RSI indicator is still the 14 candle RSI. The number 14 is mentioned in Wilder’s book. As the technology evolved, more people used computers to solve equations and analyze the market. Therefore there is no need to discuss the mathematical details of the RSI indicator, and it could be added to the chart easily just by clicking.
RSI Indicator Settings
If the chosen period for the RSI indicator is greater than 14, it will become more accurate. On the other hand, shorter periods mean less accuracy and more fluctuations. The chosen period highly depends on the trader’s strategy. Some analysts choose the 10 candle period, and some others choose the 20 candle period, but the recommended candle period is still 14 for most traders.
The overbought and oversold levels could be adjusted according to the currency pair and the kind of financial instrument that is being traded. For example, for certain currencies, levels 20 and 80 may indicate these levels with more accuracy. This will cause the number of intersections with overbought and oversold lines to decrease. It has been seen that some traders use the 2 candle period with 80/20 or 90/10 levels, which greatly increases the number of intersections.
RSI candle periods and overbought and oversold levels could vary according to the strategy in use and the market’s general condition. But it should be noted that there are no “golden” rules for determining these variables. Most traders use levels 30/70 for overbought/oversold levels and the 14 candle period for drawing the RSI indicator.
Using RSI indicator in MetaTrader4 platform
To add the RSI indicator to the chart, click on “Insert” on the top toolbar. Choose “Indicators” from the menu. The RSI indicator is an oscillator, so click on “Oscillators” and choose “Relative Strength Index” from the drop-down menu.
Using RSI indicator in CTrader platform
In CTrader, there is an “f” shaped icon. Remain your cursor still on the icon for the drop-down menu to open. Click on “Oscillators” and choose “Relative Strength Index.” There is an alternative for accessing indicators in CTrader. You just need to right-click on the price chart and simply click on “Indicators.”
Reversal Signals, Overbought/Oversold Lines
This part will explain the overbought/oversold lines and the generated signals from these lines. The main developer of this indicator recommends considering level 70 as the overbought level and 30 level the oversold level. But what is the meaning of overbought and oversold?
Overbought market
Overbought shows a period in the market that price has moved in the upward direction without any corrections. This upward movement is considered an extreme movement. Therefore it is possible to reverse any moment. Downward corrections could form due to the consolidation of traders’ profits. Therefore this correction could be both shallow or deep. This can’t be solely determined based on the overbought condition in the market, and other factors shall also be investigated.
Oversold market
Oversold occurs where the price falls straight without any upward corrections. In this case, the market could reverse at any time. Upwards corrections are mostly due to the consolidation of sellers’ profits.
If there are no bearish candles in the 14 recent candles, RSI will reach 100. If there are no bullish candles in the 14 recent candles, RSI will reach 0.
Important tips about Overbought/Oversold levels:
- Don’t rush – Some traders tend to quickly enter a position or close their previous positions as the market enters overbought/oversold regions. It shall be noted that the market’s movements in overbought/oversold conditions may be different according to the market’s trend.
* Overbought in an uptrend: Many novice traders may get surprised to see this. The market is in an uptrend and has entered overbought. But the RSI indicator is recording new highs in the overbought region. Why is that? The main reason is the upward strength of the market, which causes it to enter the overbought region and continue to rise with slight corrections.
* Oversold in a downtrend: If the RSI indicator enters the oversold region in a downtrend market, the RSI indicator could record new lows in the oversold region depending on the sellers’ strength.
* Overbought/Oversold in a range trend: The best moment to use overbought/oversold levels is when a market is ranged. Range trend indicates that the power of buyers and sellers is equal, and traders haven’t yet made their minds. Therefore the market starts to fluctuate in a defined channel. In this case, the RSI indicator could be used to enter reversing trades from the ceiling or the floor of the defined channel. - Market Corrections – Overbought/Oversold levels indicate that there is the possibility for the market to reverse at any moment. Meaning that the market will correct as soon as it reaches the overbought/oversold levels. Corrections occur in a direction opposite to the market’s trend. Therefore you may experience slight corrections, even when the RSI indicator is in the overbought/oversold regions. You must ask yourself, is this trend weak enough to trade against it? Always have in mind that trading against the market’s trend has a greater risk.
- Overbought/Oversold doesn’t guarantee a reversal. Traders shall wait until the RSI exits this region. Some traders falsely think that a buying signal is generated when RSI enters the oversold region. For the buying signal to be generated in the oversold region, first of all, price action patterns shall be taken under consideration and be evaluated simultaneously with the RSI indicator. The RSI indicator shall exit the oversold region for the buying signal to be validated.
Practical Examples of Overbought/Oversold Signals
In this section, we are going to discuss reversing signals generated by overbought/oversold levels through several practical examples. In these examples, the daily XAU/USD chart is analyzed. The entry point signals generated from the RSI indicator will be discussed in seven steps.
Before we start analyzing the market, there are several important things to point out. The first important thing about analyzing technical indicators is knowing the essence of such indicators. Some indicators are suitable for market trends (i.g Ichimoku), and others are better for range markets (i.g. RSI). Indicators aren’t solely used to generate signals. Some novice traders don’t want to analyze the market and just try to find reversing signals by adding indicators on their charts. RSI indicator can be used efficiently when used along with the price chart data.
Indicators just indicate the condition of the market and shall be used in combination with the price chart. Therefore it’s best to start with analyzing the price chart itself. We recommend using the price action method for conducting technical analysis on the market. We won’t get into details of the price action method in this RSI indicator tutorial.
Step1
In the daily XAU/USD chart, we see that the price has risen from 1120 U.S Dollars to 1350 U.S Dollars. Although the market is in an uptrend, it’s actually in a ranged trend with more tendency to upward movements. This means that the market is severely volatile, but it’s gradually forming higher highs and lows over time.
At about 1120 U.S Dollars, the RSI indicator has entered the oversold region, below the level 30. Pay attention to the market movements before RSI fell below 30. The steep downward movement of the market indicates heavy sell pressure. When the RSI indicator falls below 30, we understand that the market has fallen severely without any upward corrections. This means that an upward correction is expected to occur at any moment. Pay attention to the RSI fluctuations below 30. If you look closely, you will realize that when the RSI indicator fell below 30, the market was still moving in the downward direction. Thus have in mind that entering the oversold region doesn’t always guarantee an upward correction instantly. This is only the first warning for sellers.
The second warning is issued when the RSI gets back above 30. RSI indicator moving above 30 is the final signal for market reverse. This means that sellers are consolidating their profits and closing their short positions. Sellers exiting the market in large numbers is the first actuator of the market, which prepares it for an upward movement.
Step 2
While the RSI indicator exits the oversold region, an uptrend begins to form. This is when most traders ask how long this uptrend will last? And where does it end? According to price action analysis, the uptrend could continue until it reaches the first resistance. Look at the first high at point 1.
While the RSI indicator exits the oversold region, an uptrend begins to form. This is when most traders ask how long this uptrend will last? And where does it end? According to price action analysis, the uptrend could continue until it reaches the first resistance. Look at the first high at point 1.
Point 1 is at the same level at which the RSI indicator entered the oversold region in the first place. Therefore it’s a key region to start downward movements once more. After severe downward movements formed in the gold market, the green support level broke eventually. Thus the downtrend went on. At point 1, the RSI indicator has touched 70. Is 70 inside the overbought region itself? Yes, as the RSI indicator penetrates 70 deeper, the overbought strength increases. Thus a downward correction is more likely to happen.
Pay attention to the responses imposed by high point number 1. The price has mildly decreased, but the RSI indicator has fallen from 70 to 50. Some traders may assume RSI touching 70 isn’t a sell signal due to the presence of downward corrections. But they would be wrong. RSI reversing from 70 was a sell signal, but buyers are still dominant since the market is correcting a much bigger movement (from 1350 to 1122 U.S Dollars). Therefore a slight downward correction has occurred from point 1.
Step 3
Pay close attention to the red cross mark in the above chart. The bullish pin bar pattern indicates a strong upward movement.
At the exact point, the RSI indicator has fallen from the overbought region and touched 50. The 50 level could be considered support in upward movements. Exactly after forming the bullish pin bar pattern, the price has risen and reached the high point number 2.
As the high point number 2 has formed, the RSI indicator has reached 70 once more. After that, the market has begun another slight downward correction and reached point 3.
Why hasn’t the market started a deep downward correction after point 2? The answer to this question lies within the price action analysis. After forming the bullish pin bar pattern, the market successfully broke its previous high at point 1 and reached point 2.
Since the red resistance broke too easily, the market has moved towards it once more and changed it to support. Pay attention to the candles above the red line. Bullish candles show that the high point number 1 is no longer resistant and has changed to support. Therefore the downward correction from point 2 was slight since the newly formed support line supported it.
Step 4
From studying the above chart, we understand that the market has successfully reached high point number 3 by changing the resistance at point 1 to support and continuing its upward movement.
However, the overbought and oversold regions are our main focus in this part. It is harmless to point out the formed divergence. Have a closer look at the formation of high points 1 to 3. High points are gradually moving up, but they are formed at a certain level when looking at the RSI indicator. This indicates a downward divergence. This means that the RSI indicator doesn’t verify the formation of higher highs in the price chart. In this case, the main signal is the divergence formed in the overbought region. As the RSI indicator exits the overbought region, short positions could be taken in the gold market.
When the RSI indicator indicates a downward divergence, a downward movement is expected to happen at any moment. Thus the best thing to do is to use price action signals in lower timeframes. For example, if you analyze a daily chart, it’s better to switch to 4-hour or hourly timeframes to specify the optimum entry and stop-loss locations.
After falling from point 3, the price has penetrated below 1200 U.S Dollars. The round number 1200 has acted as a resistance and broke after two attempts. Some traders use chart patterns to analyze the RSI indicator. Look how the RSI indicator reacted above 30. A double bottom pattern has formed exactly after the severe downward movement of the market, and the market has entered an uptrend.
Was this a valid signal to enter long positions? The application of double top or double bottom patterns in the RSI indicator is a whole other discussion, to which the answer is yes. In this case, the only thing that can help traders is their own experience since the market isn’t clear.
But there is another way to validate the upward reversal from the yellow box. Pay attention to the above chart. This is not a divergence. Most traders don’t know the difference between divergence and positive reversal. A higher low is formed in the price chart, but in the RSI indicator, a lower low is formed between 30 and 50. This means that, although the market wanted to fall (RSI indicator has fallen), but the price chart wasn’t successful in forming any lower lows just yet. When lows are formed above lows, the general trend of the market is an uptrend. After the formation of positive reversal and RSI indicator moving above 50, a strong bullish candle has formed that engulfed 5 candles before it. This candle is a long signal in the gold market.
Step 5
After gold reversing from 1200 U.S Dollars, the price struggled with the high point 3 for a while and fluctuated below the red line. Finally, the price got through and reached the high point number 4. The high point 4 is exactly coincident with the price of gold after the United States presidential election (2016 presidential election), which is below the 1300 round number. If any reversals are to happen, the most suitable location are key levels of the market.
Being close to the resistance level at 1300 U.S Dollars and being in the overbought region could be a valid downward movement signal. Note that when the RSI fell below 70, a bearish engulfing daily candle has formed. This candle has successfully engulfed three candles before. So the price action selling signal is the bearish engulfing candle, and the RSI indicator has validated it.
Step 6
Always find the most probable location for a signal to happen before finding it. Strong signals generate when the market reacts to a key level. You can see that after reaching high point 4, the market started to fluctuate between two levels. After falling from point 4, the market has fallen to the green support line. This green support line is at the same level as was high point number 1. As the market reaches the green support, the RSI indicator reaches 30. After that, the market rose to high point number 5.
When reversing from point 5, the RSI indicator hasn’t reached 70 and reversed below it. Does this count as a reversal signal? Reversal signals are generated from overbought and oversold levels. But the market hasn’t entered the overbought region in this case. We will remind you that indicators can’t generate signals themselves and shall be analyzed beside the price chart. In the above chart, the price has reached a strong resistance, which is parallel to point 4. A double top has formed in the price chart, while in the RSI indicator, point 4 is above point 5. Therefore we can say that a slight downward divergence has formed.
The price wasn’t able to break its previous high according to price action. Therefore a range trend occurred. New lows are either higher than the previous ones or are at the same level as them. This means that the overall trend is an uptrend. But when new highs aren’t above previous highs, short positions can be taken carefully. Such condition in the market indicates a range trend with a tendency to becoming an uptrend. In this case, either enter the market on the green support or wait for the red resistance to break.
Step 7
The price has fallen to the support line from point 5 once more. Bullish pin bars forming around this support and also RSI indicator reaching 30 were signs of a bullish market. Pay attention to the market’s response in point 6. The market struggled with the red resistance line for a while and eventually broke it upwards and reached point 7.
Was the reversal signal generated from the overbought region false? Predicting the market is difficult. But the most probable path could be determined based on current clues. When resistance is touched 3 times and corrections occur, it means that the power of sellers has decreased, and the resistance may break in future attempts. The engulfing bullish pattern has offset the previous day’s fall. If you have entered a long position from point 6, that’s not a bad idea, but you should closely monitor your trade. Therefore, when seeing such bullish candles, move your stop loss to the entry point as soon as possible so that in a worst-case scenario, you would exit the trade without loss.
Trendlines can also be drawn and used in the RSI indicator. Pay attention that when the high point 7 formed, a strong bearish pin bar candle has formed in 1350 U.S Dollars. Meanwhile, the RSI indicator has entered the overbought region and formed two equal highs. By RSI exiting the overbought region, the green trendline is broken. This means that the short signal generated by price action is validated by the RSI indicator.
Reversal signals: Divergence
In this part of this tutorial, we are going to discuss divergence in RSI indicators from a practical point of view.
Divergence happens when the strength of price movements isn’t verified by the RSI indicator. In case of such an event, the price chart continues to form higher highs, while RSI keeps forming lower highs. This means that the RSI indicator doesn’t verify the upward movement of the market. There are generally two forms of divergence:
Upward divergence: This divergence happens when the price is forming lower lows, but the RSI indicator is forming higher lows. This means that the RSI indicator doesn’t verify the market’s downward movement, and sellers are getting weaker.
Downward divergence: This divergence happens when the price is forming higher highs, but the RSI indicator is forming lower highs. This means that the RSI indicator doesn’t verify the upward movement, and buyers are getting weaker.
Important tips about divergence
- If divergences happen after touching the overbought and oversold levels, they will greatly affect the market.
- Divergences can generate false signals when in a strong trend. For example, the market is in a strong uptrend, but several downward divergences are visible before the formation of the high. Or, in strong downtrends, several upward divergences form, but the market keeps going down. Divergences indicate upward and downward corrections. Therefore when a market has a strong trend, divergences only point out slight corrections. But if the market is in a ranged trend, divergences could generate strong reversal signals.
The red and green lines show divergences in the RSI indicator. Look closely at the location of divergences. They are formed either on the oversold level or the overbought level. The first divergence on the left is formed in the oversold region. While RSI is exiting the oversold region, the price is forming lower lows. Pay attention that the market has reversed in response to the formed divergence. This upward divergence has also formed a fake low. Pay close attention to the RSI movement above 30. The RSI indicator has moved above 30, touched it once more, and bounced back up. The best moment to enter a long position is when the RSI indicator has broken its previous high by touching 30 once more.
The second divergence has formed on the descending trendline. A double top pattern has formed in the price chart, which is a kind of reversal pattern. Meanwhile, the RSI indicator is indicating the formation of lower highs. Pay close attention to the market’s condition at the time of the reversal signal. The market has formed a downward divergence while forming a double top at the round number 0.67. This means that all factors are in favor of a downward movement in the market. The third divergence is an upward divergence. This divergence has formed in the oversold region and is coincident with the round price of 0.65 U.S Dollars.
Reversal Signals: Failure Swing
In this part, we are going to discuss reversal signals generated from failure swing.
Wilder believes failure swing could generate strong reversal signals. Failure swing has nothing to do with the price chart and is solely obtained from the RSI indicator.
- Failure swing bottom (Upward reversal signal _ long signal): RSI indicator is in the oversold region. The RSI indicator moves towards 30 after exiting the oversold region. But it rises from 30 and breaks the previous high.
- Failure swing top (Downward reversal signal _ short signal): The RSI indicator is in the overbought region. The RSI indicator moves towards 70 after exiting the overbought region. But it falls from 70 and breaks the previous low.
Failure swings indicate that the market won’t return to the overbought and oversold regions after leaving them. This means that the buyers’ strength (in overbought) and sellers’ strength (in oversold) is significantly decreasing, and the market will soon begin a strong reversal.
The price is fluctuating about 0.6550 in the above chart. Pay attention to the formation of price candles around 0.6550. Generating signals in this situation is very difficult, especially when price action patterns are being used solely. However, adding the RSI indicator to the chart could easily show us the suitable time and location to take a long position. The RSI indicator has exited the oversold region but moved towards 30 once more (red arrow). As time passes, the RSI indicator breaks its previous high, which is a strong long signal.
The market has moved 50 pips away from 0.6550 and rose over 0.66. While the market reaches this level, we see a downward divergence forming. The downward divergence is showing the end of the upward movement. This is both a signal for closing your long position and to take a short one.
In the below 30-minutes USD/JPY chart, a failure swing top has formed. Look at the high formed in the price chart. Candles are fluctuating in this region. Determination of the next movement of the market would be difficult in such conditions. But if you look at the RSI indicator, the market has exited the overbought region, and moved towards 70 once more, and bounced back. When the green line breaks in the RSI indicator, a short signal is generated.
Reversal Signals: Positive-Negative Reversals
In this part of this tutorial, we are going to discuss Positive-Negative reversals.
Positive and negative reversals were added to RSI applications by Andrew Cardwell. Positive and negative reversals are the exact opposite of divergence. It shall be noted that Cardwell’s approach towards the RSI indicator was different from Wilder’s. This causes most analysts to get confused when working with positive-negative reversals. It shall also be noted that in divergence, the main focus is on the RSI indicator, which means that it’s the RSI indicator that confirms the formed lows and highs in the price chart. While in positive-negative reversals, the main focus is on the market’s price movements, which means that the highs and lows in the price chart verify the formed highs and lows in the RSI indicator.
Positive reversal
In positive reversal, the RSI indicator forms lower lows, while the price chart forms higher lows. These lows aren’t formed on overbought/oversold levels, and they are rather formed between 30 and 50.
Negative reversal
In negative reversal, the RSI indicator forms higher highs, but the price chart forms lower highs. Highs are often formed between 50 and 70 in the RSI indicator.
But what is the main concept of positive and negative reversals?
The price is forming lower highs in negative reversals, but the RSI indicator is forming higher highs. This means that, although RSI indicates the higher power of buyers, the price hasn’t risen much. Therefore, the power of buyers is decreasing, and a negative reversal may happen.
In positive reversals, although RSI indicates the high power of sellers, but lower lows couldn’t form in the price chart; thus, we can say that sellers are getting weaker.
In the above chart, a positive reversal is taking place. Pay attention to the formation of new lows in the price chart. Higher lows are appearing in the price chart, while the RSI indicator is forming lower lows. There are several differences between signals generated from divergences and the ones generated from reversals:
- Positive reversals happen between 30 and 50, while divergences happen on an oversold region (below 30).
- Negative reversals happen between 50 and 70, while divergences happen on an overbought region (above 70).
- In negative reversals, the first high in the RSI indicator is lower than the second high (second high>first high), while in divergences, the first high is higher than the second one (first high>second high).
- In positive reversals, the first low is higher than the second low (first low>second low), while in divergences, the first low is lower than the second one (second low>first low).
RSI Range in Uptrend and Downtrend Markets
In this part, we are going to discuss the RSI range. In uptrend and downtrend markets, other ranges can be used.
In “Technical Analysis for the Trading Professional,” Constance Brown mentions that the RSI indicator doesn’t always move between 0 and 100. He defines a new range for the RSI movement in this book. RSI movement range in uptrend and downtrend markets is explained below:
Uptrend
RSI indicator usually moves between 40 and 90. In an uptrend market, the region between 40 and 50 in the RSI indicator is the supporting region of the market. This means that if the RSI indicator reaches these levels, an upward movement is expected in the market.
In the above chart, a mild uptrend is happening. Compare the time of upward reversals with the RSI indicator. The market is in an uptrend, but in all downward corrections, the RSI indicator has only moved as low as 40-50 levels (the supporting region). But the price kept going up, and the RSI indicator moved above 40-50. Therefore, it is always recommended that the RSI indicator is used in combination with the price chart. The RSI indicator only informs the trader about the market’s condition. The RSI indicator reaching 40-50 might mean the end of the downward correction in an uptrend market. But could we conclude solely on this evidence?
Downtrend
RSI indicator usually moves between 10 and 60 in downtrend markets. The region between 50 and 60 is considered the resisting region of the market. This means that if the RSI indicator reaches this level, a downward movement is expected.
In The daily NZD/USD chart above, the market is in a downtrend. Pay close attention to the RSI’s response to 50-60 levels. Each time the indicator reaches this level, a downward movement occurred in the market. These downward movements are in accordance with the market’s trend. Although no clear signals are generated in these levels, but the RSI indicator warns us about trading on this level. Because the downtrend keeps its strength, the best region for a downward reversal is at 50-60 levels.
Median Line in RSI Indicator
In this part, we are going to discuss the application of the median line (50 line) in this indicator.
All oscillators have median lines, to which traders often don’t pay attention. The 50 level is the median line of the RSI indicator. Traders can use this line to analyze the market. If the RSI indicator is above 50, the market is leaning towards an uptrend. Thus traders should be looking for long signals. But if the RSI indicator is below 50, the market will probably start a downtrend.
A strong downtrend is going on in the above chart. This downtrend has started when the RSI indicator fell below 50. The RSI indicator had remained below 50 during the fall and got back above 50 when the market started rising.
One of the most important applications of the median line in the RSI indicator is determining the end of an uptrend or a downtrend. For example, The market is rising in the above chart. The RSI indicator is above 50, from the beginning of the upward movement. However, it fell below 50, when the trendline in the price chart broke downwards. This means that the upward movement of the market has come to an end.
RSI Indicator Tutorial Conclution
This article explained step by step how to use the RSI indicator properly, but remember RSI is not enough to get the full picture. It only comes to strengthen the possibility of reversals or trends in the market.
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