Relative Strength Index (RSI) explained in simple terms

Written by
Tamás P.
Fact checked by
Gyula L.
Updated
Apr 2023

The Relative Strength Index (RSI) is one of the most popular technical indicators in forex trading. Developed by technical analyst J. Welles Wilder, the RSI  is primarily used to gauge oversold and overbought market conditions based on recent price movements. 

THE ESSENCE

  • The RSI is a widely used technical indicator developed by J. Welles Wilder
  • The RSI moves on a scale of 0 to 100
  • The RSI indicator shows whether an asset is oversold or overbought
  • The RSI is useful in confirming trends and spotting divergences

How the Relative Strength Index (RSI) works

The RSI is an oscillating momentum indicator, which fluctuates between 0 and 100. It forms a graph like a price chart.

The RSI is calculated using the following formula:

RSI = 100 - [100 / (1 + (Average of upward price change / Average of downward price change))]

The RSI has one parameter, the RSI length. It is the amount of trading time frames (e.g. days on the daily chart, hours on the hourly chart, etc.) used in the calculation of RSI. The lower this number is, the more signals the RSI will produce, but they will be less accurate.
As with any other technical indicator, using the RSI alone will not serve you well in the long run, because it may produce fake signals, and does not contain enough information for a complete strategy.

How to trade using the RSI

The RSI is mainly used for two things: 

  1. to confirm trends and spot divergences, 
  2. to determine oversold/overbought conditions.

Determining market trends and divergences with the RSI

Traders rely on the RSI to help you confirm market  trends. When the RSI value is below 50, you are looking at a possible downtrend. If you think the price chart shows an uptrend, check whether the RSI is above the 50-level.

RSI is a momentum indicator and momentum indicators are good for identifying divergences. The price chart and the RSI create higher highs and higher lows in an uptrend, and lower highs and lower lows in a downtrend. If the price is moving in one direction and the RSI creates an opposite peak, it is a sign for a possible trend reversal.
In the illustration below, you can see a downtrend. While the price continues to make lower lows, the RSI graph creates a higher low. Afterwards, the price started to advance in the opposite direction, so the signal was right.

Oversold and overbought condition

The RSI also signals when a currency pair is overbought or oversold. 

Most traders will consider a currency pair overbought if the RSI reading is 70 or more and build their strategy on the assumption that the currency is likely to weaken (sell signal). 

Conversely, a reading of 30 or below, indicates that a currency pair is oversold and there is an opportunity that the price will go up (buy signal). Some traders prefer to use the 80/20 marks instead of 70/30.
The larger your time frame (i.e. days, weeks or months), the more accurate the signals will be. On narrower time frames, fake signals will emerge randomly.

FAQ

What does it mean if the RSI is below 30?

If the RSI value is below 30, it is commonly considered that the asset is in ‘oversold’ condition and the price may start rising. Some traders interpret a below-30 RSI reading as a buy signal but this is not a commonly accepted thinking in the trading universe. 

How to use the RSI for day trading?

Ideally, a daytrader should configure the RSI from the default 14 parameter to something lower, that way it generates more oversold or overbought signals within a day, and combine it with other forms of technical and fundamental analysis.

Should I buy an oversold asset?

The interpretation of the oversold condition is ambiguous among traders. Some consider an overbought condition as a potential entry point while others do not. In theory, oversold means that the asset is currently trading in the lower end of its recent price range but this does not necessarily mean there is a price trend reversal coming. An asset should not be bought merely based on this.

 

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Further reading

Author of this article

Tamás Pápai

Tamás is a former Broker Analyst Intern for BrokerChooser. He studied at the Budapest University of Technology and Economics and his main field of interest is investing and trading, specifically forex trading. This was his first position in the financial field; previously, he worked in other areas of economics. His goal is to create easy-to-understand and in-depth educational content and develop the accuracy of the recommendations to users.

Everything you find on BrokerChooser is based on reliable data and unbiased information. We combine our 10+ years finance experience with readers feedback. Read more about our methodology.

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