Relative Strength Index

What is Relative Strength Index (RSI) in forex and CFD trading

The Relative Strength Index (RSI) is a momentum oscillator, developed by J. Welles Wilder, that measures the speed and change of price movements, scaled from 0 to 100. The Relative Strength Index matters for real trading decisions because it identifies overbought (RSI > 70) and oversold (RSI < 30) conditions, signaling potential trend exhaustion or reversal points, and helps confirm the strength of a prevailing trend. To understand these and other trading concepts, refer to our comprehensive glossary.

Key facts about Relative Strength Index (RSI)

• Classification: A leading momentum oscillator, plotted in a separate window below the price chart.
• Scale: The indicator is normalized to oscillate between 0 and 100.
• Default Period: The most widely used lookback period for calculation is 14 periods (e.g., 14 days, 14 hours).
• Overbought Condition: An RSI reading above 70 suggests the asset is overbought, indicating selling pressure may increase.
• Oversold Condition: An RSI reading below 30 suggests the asset is oversold, indicating buying pressure may increase.
• Centerline: The 50 level often acts as a dividing line, where movement above 50 suggests upward momentum, and below 50 suggests downward momentum.
• Divergence Signal: A common reversal signal occurs when price makes a new high (or low) but the RSI fails to confirm with a new high (or low), suggesting momentum is weakening.

How Relative Strength Index (RSI) works in forex and CFD trading

The Relative Strength Index (RSI) works by analyzing the average magnitude of gains versus the average magnitude of losses over a set period, translating this volatility into a value between 0 and 100 that quantifies momentum.

Calculation follows these steps:

• Calculate Average Gain (AG) and Average Loss (AL): For the first 14 periods, the sum of upward price changes is divided by 14 to get the initial AG, and the sum of downward price changes is divided by 14 to get the initial AL.
• Calculate Relative Strength (RS): The ratio of the average gain to the average loss is determined: RS = AG / AL
• Normalize to Index: The Relative Strength Index formula normalizes the RS value into the 0 to 100 range, making it readable as an oscillator: RSI = 100 – (100 / (1 + RS))
• Signal Generation (Crossovers): When the RSI crosses below 70 after being overbought, it generates a sell signal; when it crosses above 30 after being oversold, it generates a buy signal.
• Confirmation (Divergence): Traders observe divergences between the price trend and the RSI trend for stronger reversal confirmation.

Example of Relative Strength Index (RSI) with a real trade

This example demonstrates using the Relative Strength Index (RSI) to generate a sell signal on EUR/USD based on the overbought condition.

• Instrument: EUR/USD on the H1 chart
• Indicator Used: 14-period Relative Strength Index
• Condition: EUR/USD price has been rising rapidly, and the RSI reaches 78 (Overbought).
• Entry Signal: The RSI line crosses back below the 70 level at a price of 1.10850.
• Entry: Sell Market Order placed at 1.10850.
• Stop-Loss: 1.11050 (Placed 20 pips above the high).
• Position size: 1 standard lot (100,000 units).

Trade Calculation (Hypothetical successful reversal trade):

The RSI signal is confirmed, and the Sell Market order is executed at 1.10850. Price reverses, dropping to 1.10050, where the trader closes the position.

• Gross Profit (Pip Gain): 1.10850 – 1.10050 = 80 pips
• Spread Cost: 0.2 pips × $10/pip = $2.00
• Commission: $0.00 (zero commission structure)
• Net PnL: (80 pips × $10/pip × 1 lot) – $2.00 = $798.00

Result: $798.00 net profit. The Relative Strength Index provided a momentum-based timing signal for a trend reversal. Zero commission structure eliminates per-trade commission fees, maximizing the benefit of the RSI signal.

How Relative Strength Index (RSI) affects your cost and risk

The Relative Strength Index primarily affects risk by providing objective levels for trade entry and exit, which helps in calculating precise risk per trade, but it is not directly related to transaction cost.

Relative Strength Index (RSI) compared with related concepts

Relative Strength Index (RSI) vs Stochastic Oscillator

The Relative Strength Index measures the speed and magnitude of price changes, comparing the average gain to the average loss, and is generally considered better for identifying trend strength and divergences. The Stochastic Oscillator measures the closing price’s position relative to its price range over a period, making it a smoother indicator that is often more reliable for identifying short-term overbought/oversold extremes at faster settings. Both are momentum oscillators, but the RSI is a smoother measure of underlying strength, whereas the Stochastic is a more reactionary measure of price location.

Relative Strength Index (RSI) vs Moving Average Convergence Divergence (MACD)

The Relative Strength Index is an oscillator that operates in a bound range (0-100) and is specifically used to gauge overbought/oversold conditions and divergences. The Moving Average Convergence Divergence (MACD) is an unbounded, trend-following momentum indicator derived from the difference between two Exponential Moving Averages, used primarily to identify trend changes and momentum shifts relative to its centerline, not absolute overbought/oversold levels.

Broker differences in Relative Strength Index (RSI) across the industry

Brokers mainly differ in the range of customization allowed for the Relative Strength Index and the quality of the price data used for the underlying calculation.

How to verify Relative Strength Index (RSI) on your trading platform

Verifying and using the Relative Strength Index (RSI) involves adding it to the chart and checking its key settings.

• Open Indicator List: In MetaTrader 4 (MT4), navigate to ‘Insert’ > ‘Indicators’ > ‘Oscillators’.
• Select RSI: Choose the ‘Relative Strength Index’ indicator and open its parameters window.
• Set Period: Ensure the ‘Period’ is set to the standard 14 (or your custom setting).
• Set Levels: Navigate to the ‘Levels’ tab and confirm the primary overbought and oversold values are set to 70 and 30.
• Confirm Display: Check that the RSI is displayed in a separate pane below the price chart, oscillating within the 0 to 100 range.
• Verify Divergence: Look for a price high that fails to correspond with a high on the RSI line, confirming negative divergence.
• Check Sensitivity: Change the period from 14 to 6 and observe how the RSI line becomes spikier and more sensitive to minor price fluctuations.
• Sanity check: The RSI line must never drop below 0 or rise above 100, and the default 70/30 levels should be immediately visible as horizontal lines.