The RSI index is an important assessment tool to measure fluctuations between overbought and oversold conditions in the market. This is an important index that investors regularly use to analyze the foreign exchange situation. So, what is RSI? How to calculate RSI? Let’s explore Forex Trading in detail through the article below!
General overview of how to calculate RSI
Based on RSI, investors can determine the right time to open or close an order. There are many ways to apply the RSI indicator. Includes combinations with many different time frames. Use indicators such as Bollinger Bands and SMA lines. Or even candlestick reversal patterns, as well as trading based on divergences…
What is RSI?
RSI index, short for “Relative Strength Index”. This is a popular tool used for technical analysis in the foreign exchange market. It was developed in 1978 by mechanical engineer John Welles Wilder Jr. This index is used to measure price fluctuations over a recent period of time. To help investors recognize when the market is overbought or oversold.
The RSI index shows fluctuations between two extremes. It is represented as a graph that ranges from 0 to 100. It compares the ratio between the number of days of decline and the number of days of increase. Usually, it uses a fixed parameter for calculation, usually 14 days.
Calculate the limits of the RSI index
Although the RSI index is considered an important and popular tool for analyzing market trends. It decides when to buy and sell stocks. However, it is not always effective for all markets. In particular, RSI faces many difficulties when used in markets with strong and prolonged fluctuations.
In strongly down-trending markets, positive divergence signals may appear on the RSI. This confuses investors into thinking it is the ideal buying point. However, after that, the price continued to decrease further. Conversely, in a strong bull market, negative divergence signals on the RSI can be confusing. This leads many to believe that it is the selling point. This led to the sale of shares but the price continued to increase.
Therefore, How to calculate RSI is usually only useful in low-volatility situations. Like when the market has no clear trend or is fluctuating in a narrow range. Compared to how to calculate purchasing managers index, RSI has more flexibility in measuring price fluctuations.
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Meaning of RSI index in technical analysis
The RSI index plays a very important role for investors. To help them determine the right time. The purpose is to open or close orders based on the signals it provides.
Overbought and oversold zoning
To identify bullish/bearish signs of the market, we can use the RSI line. Move between levels 0 and 100. However, when applying How to calculate RSI, we are interested in two main areas. Those are the Overbought Zone and Oversold Zone.
- Overbought zone: When RSI crosses the 70 threshold, it indicates that the market is in an OVERBought state. When the price goes far beyond the equilibrium level. Usually occurs in a market that is in an uptrend. This is a warning signal that the market may be about to reverse.
- Oversold zone: When the RSI falls below 30, it indicates that the market is in an OVERSOLD state. When the price is too low compared to the equilibrium level. Usually occurs in a market that is in a down phase. This is often a warning signal that the market may be about to reverse.
Predict up and down trends with how to calculate RSI
The RSI line can predict the future trend of the market. In a strong bull market or uptrend, the RSI line usually remains between 40 and 90. In particular, the 40-50 zone often acts as a support zone.
An uptrend in price is recognized when: (1) The RSI line crosses the 50 threshold from below or (2) the RSI line is between 45 and 55 and goes above the 55 threshold.
On the contrary, in a strong downtrend or downtrend, the RSI line usually moves between 10 and 60. The 50-60 zone is often the resistance level.
A downtrend is recognized when: (1) The RSI line drops below the 50 mark from above. Or (2) When the RSI line is between 45 and 55 and falls below the 45 threshold.
Identify price divergence – convergence
Convergence divergence between price and RSI is also a method to determine the trend. Similar to using the MACD line’s convergence divergence indicator. RSI can change its behavior to signal a market reversal.
- When there is a divergence, the market makes a new higher high while the RSI line is falling. This shows a bearish reversal signal of the market. When there is a divergence, we observe an opposite movement between the tops or bottoms of the price and the RSI.
- Vice versa, when there is a convergence between RSI and price. At this time, the market creates a new lower low while the RSI line is increasing. It represents a bullish market reversal signal. When there is convergence, we observe close movements between the tops or bottoms of the price and the RSI.
Instructions on how to calculate RSI
How to calculate RSI is quite simply, expressed as follows:
RSI = 100 – [100/(1+RS)]
In there:
- RS (Relative Strength) is calculated by averaging the ratio between total profits in up periods and total losses in down periods.
- The default parameter of RSI is 14 periods.
How to use the RSI indicator effectively in Forex technical analysis
Here are some effective methods How to calculate RSI in technical analysis:
Identify trends using the RSI Indicator
According to Wilder, the father of RSI, any RSI signal that crosses the 70 threshold is considered overbought. This is an opportunity for investors to sell (sell signal). Conversely, when the RSI is below 30, it is considered oversold. This creates an opportunity for investors to buy (buy signal).
When the RSI is between 30 and 70, the market is considered average. When RSI is in the range of 45-55, it usually indicates uncertainty in the market trend. Investors often wait for signals to cross the 30 threshold (buy signal). At the same time, cut the threshold of 70 down (sell signal).
In some cases, if a stock consistently reaches overbought levels above 70 or oversold levels below 30, this threshold will be adjusted up to 80 and down to 20 respectively. This helps limit false signals and depends entirely on the investor’s decision.
RSI Divergence signal usually diverges
In addition to using the 30 and 70 thresholds of the RSI index to evaluate overbought or oversold market conditions, RSI provides investors with another method to predict market trend reversals or identify market trend reversals. Identify resistance and support levels using bullish divergences (called positive divergences) and bearish divergences (called negative divergences). It is also one of the popular Scalping indicator, assisting traders in selecting short-term trading opportunities.”
Specifically:
- Bullish divergence (positive divergence): This occurs when the RSI creates a new bottom higher than the old bottom while the price creates a new bottom lower than the old bottom. This signal is called a bullish divergence. It indicates the price is trending upward again, despite the previous downtrend (buy signal).
- Bearish divergence (negative divergence): Occurs when RSI creates a new peak lower than the old peak. While the price creates a new peak higher than the old peak. This signal is called bearish divergence. It signifies that buying power has reached its maximum level and the market is losing momentum. Therefore, the price will tend to decrease (sell signal).
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Signal of hidden RSI divergence (RSI Failure Swing)
Similar to regular RSI divergence signals, but with the hidden divergence RSI signal (failure swing), we do not care about the price but only focus on the RSI signal. There are two types of hidden divergences as follows:
Hidden bullish divergence:
- RSI dropped below 30 (oversold).
- RSI increased again to surpass 30 (failure point).
- RSI continues to decrease but is still above the 30 level (oversold).
- RSI increased again and crossed the failure point, creating a buy signal.
Hidden bearish divergence:
- RSI increased above 70 (overbought).
- RSI fell back below 70 (failure point).
- RSI increased slightly but was still below 70 (under-overbought).
- RSI fell deeply below the failure point, creating a sell signal.
Conclude:
Above, Forex Trading has provided information about the concept, meaning, and how to calculate RSI. From the above article, we have an overview of the concept and how to use it in technical analysis. However, to have the most accurate prediction of market trends, it is necessary not only to apply RSI but also to combine many other methods such as Stochastic and MACD. Hope this article brings value to you and wish you successful trading!
Frequently asked questions
In what markets can RSI be applied?
RSI can be applied in most financial markets. Including forex, commodities, and cryptocurrency markets.
What signals can RSI be used to identify?
RSI is often used to identify buy or sell signals based on overbought or oversold levels.
How to use RSI in trading?
RSI is often used to identify buying and selling points. Traders can use overbought and oversold levels (usually 70 and 30) to identify these points.
