The Relative Strength Index (RSI) indicator is one of the most popular technical indicators among forex traders.
What is RSI indicator? The Relative Strength Index (RSI) was first introduced by J. Welles Wilder in 1978 in his book "New Concepts in Technical Trading Systems". The RSI indicator is then known as an Oscillator indicator with levels from 0 to 100.
The RSI Indicator Period used as a standard by Wilder is 14. However, the period can be replaced to be smaller or larger, according to the level of needs of each trader. Most traders only use RSI like other Oscillator indicators: only to see Overbought and Oversold signals. But apparently, the RSI Indicator can be used for more than that.
How to Calculate RSI indicator?
In calculating the RSI indicator value, there are several components that must be calculated first. These components are RS, average increase, and average decline. If you use a standard period from Wilder, the formula to calculate it is:
RS = Average increase/decrease
Average increase = (previous increase average x 13) + last increase) / 14
Average decline = (previous decline average x 13) + last decline) / 14
The average increase or decrease is the difference in the closing price of the market. For example, suppose the price of 1 hour ago is closed at level 2, while the current price is at level 5, then there is an increase of 3 points. This increase will be counted for 14 candles in each time frame. Furthermore, the RS value will be used to calculate the RSI indicator value. The following formula is used:
RSI = 100 - (100 / (1 + RS)
How RSI works?
Traditionally, the RSI indicator is used to determine the right time of entry by looking at overbought and oversold levels and detecting possible changes in direction of the trend by observing divergence towards price movements. Apart from using it for general RSI functions, there are other tips from traders who might be able to help in using this indicator.
RSI has values from 0 (zero) to 100 (one hundred). RSI can help you to predict overbought and oversold conditions. The market is considered overbought if the RSI is below 30 and is considered overbought if the RSI is above 70.
How to use RSI?
Like oil, the price of an asset also has a saturation point, both because it has been too long (Overbought) or down (Oversold). In determining this saturation level, a certain level of the indicator is usually set which can represent its saturation.
Market saturation can also be measured using the RSI indicator. Generally, levels 70 and 30 are used as limits, which means that if the RSI indicator value is above 70, the price is Overbought. Whereas if the RSI indicator value is below 30, the price is Oversold. Some people also often use level 80 and 20 as standards, so this reference is not standard
In the above example, the two conditions, in general, have been described, namely Overbought on the RSI indicator value above 70, and Oversold when the RSI indicator value is below 30. It should be noted that not always Overbought and Oversold conditions will lead to a long reversal as exemplified. More often, prices will continue to go up and down because the trend is still strong. In order not to get caught in false signals, it is recommended to combine RSI with other technical indicators.
Traders often use the RSI indicator as an aid in making trading decisions. One example that is often used is a combination of Bollinger Bands and RSI.
Besides seeing the level of market saturation, traders also often use the RSI indicator to see when the trend will change. The beginning of this change can be detected by seeing penetrations at certain levels in the market.
In seeing or determining trends, traders usually use the Moving Average or Channel. However, not only these two technical indicators can be used as references. RSI has its own way of determining trends. In determining trends through the RSI, level 50 is needed as a barrier. If the RSI signal is above 50 then the trend is going up, while if it is below 50 then the trend is going down.
Besides to determining trends, level 50 can also be an early sign of a trend change. This can be marked by breaking level 50. This crossing is also commonly known as The Centerline Crossover, or a midline break with the RSI signal.
RSI Indicator As A Reader For Divergence
Just like the Stochastics and MACD indicators, RSI can also be used to read divergence that is happening on the market. According to Wilder, signal divergence can be a reversal point in a trend. This is possible because the price does not have the strength to continue the journey.
A bullish divergence signal occurs when the price on the chart appears to form a lower low, but the RSI signal forms a higher low. While for the bearish divergence signal occurs when the price on the chart appears to form a higher high, but the RSI signal actually forms a lower high. For more details, refer to the following example:
RSI bullish divergence
RSI bearish divergence
Using the RSI Indicator with Support Resistance
Apart from the above methods, the RSI can also be used like trading with a naked chart. So, trading only uses the RSI indicator and the Support Resistance line only. Resistance lines can be formed with several results points from the experiment failing prices for. For the support line, it can be formed with a number of points resulting from failed attempts to fall.
After the Support and Resistance lines are formed, what needs to be considered is when the price approaches this level once again. It should be observed carefully, whether the price will break out at that level or rejection will occur. Break out means the price will continue its journey, while rejection means the price will reverse.
Special Case: Failure Swing
This method of use is specifically classified by Wilder because even though the appearance rate is rare, the accuracy is very high. Failure Swing is a condition that is almost the same as divergence, namely the inability of prices in continuing the trend journey. It's just that in this condition, Wilder requires to pay attention to the RSI value only.
The Failure Swing Bullish occurs with the following conditions:
*The RSI moves down 30 so that Oversold occurs.
*Prices move quickly to reply until the RSI bounces up from levels below 30.
*RSI will try again to break level 30, but failed.
*The RSI will move up through the highest level number 2.
Bearish Failure Swing occurs with the following conditions:
*The RSI moves above level 70 so that it is Overbought.
*Prices move quickly to reply until the RSI bounces down from level 70.
*RSI will try again to break level 70, but failed.
*The RSI will move down through the lowest level number 2
However, in practice, traders will often find that:
1. The indicator does not come out from below level 30 or vice versa does not go down from level 70, even though it has been for days. This is a "trending" market situation. If you are not ready to deal with it, then you can get stuck floating negatively for a long time and end up exposed to the Margin Call.
2. The indicator does not go above level 70 or falls below level 30, even though it has been for days too. This is usually related to the "sideways" market situation and low volatility. If you are not ready to deal with it, then you will not be able to open trading positions because there is no signal.
Steps to Optimize the RSI Indicator
In order not to get caught up in the myth of the inaccuracy of the RSI indicator due to the two cases above, you can try applying the following steps:
Slide the oversold threshold and overbought RSI to levels 20 and 80. On the Metatrader platform, an option like this will appear to customize the RSI indicator. Choose 20 and 80 so that the level is automatically marked by the platform. This step allows traders to sort oversold and overbought signals more accurately, rather than staying on level 30-70.
For buy or sell trading signals, pay attention to the level 50 midline. If the RSI indicator rises above 50, it means it's time to find a moment to buy. Whereas if the RSI is below the level of 50, it means it's time to sell. Preferably, don't use oversold and overbought levels as a marker for buy or sell; but as a marker of time to close a trading position.
Change the period parameters on the RSI indicator according to your trading period. By default, the RSI indicator has a period 14 setting. However, short-term timeframe traders (H4 or lower) should use smaller periods, for example, 9. Whereas long-term traders should use a higher period, for example, 25. This parameter can also be modified easily on the Metatrader platform. Try setting the RSI indicator this way, then practice it.