The world of technical analysis is very broad. There are hundreds of different indicators to choose from which attempt to predict future price movement using past price action. There is no perfect indicator and there is certainly no one size fits all. Each indicator has its own pros and cons. Some indicators are more popular than others. One particularly popular indicator is the relative strength index also known as the RSI.
This indicator aims to show when the market is overbought or oversold. It falls within the group of indicators known as oscillators, giving a value between 0 – 100 measuring how strong or how weak a price is over a period of time.
The formula is as follows:
RSI = 100 – (100/(1+RS)
In other words
RSI = Average gain / average loss
Whilst it is useful to see and understand the calculation, you will not need to do this yourself. Charts will do the calculation and plot the RSI for you.
Interpreting the numbers
The idea of the RSI is to understand when a market has traded too far in one direction. These are considered unsustainable price extreme, beyond which a reversal is expected
An RSI reading of 70 or higher indicates the market is overbought. In this scenario you would expect the price to reverse and sell off. Once the reversal has been confirmed a sell trade should be placed.
An RSI reading of under 30 points to a market which is oversold. The expectation would be for the market to start rising again. In this scenario a buy trade should be placed once confirmation of the reversal has been achieved.
Points to watch for:
The thing to be aware of is these numbers are not hard and fast numbers. A market could remain in overbought or oversold territory for some time before it reverses. Entering too soon could be a costly error. For this reason, it is essential that you await confirmation on a reversal.
The RSI should therefore always be used with another indicator, such as price action, price patterns or other technical indicators.
This is a very popular trend identifier, an identifier of sentiment which highlights bullish or bearish trends in the market and potential reversals under overbought or oversold conditions. It has stood the test of time and is actually fairly simple to use, which is why so many traders opt to include the RSI in their trading approach.
Vantage FX provides its clients with a comprehensive charting package. RSI indicator can be found on Vantage FX charts on all its platforms and on MT4. If you are unfamiliar with the indicator you can find it and add it to your chart by following these steps on the MT4 platform:
Insert – Indicators – Oscillators – Relative Strength Index