The Relative Strength Index and it’s Strengths and Weaknesses for Forex Traders

One of the most commonly known technical indicator is the RSI (Relative Strength Index). In this training article, we will explain what it’s function is, and where it has it’s failures.

If you are familiar with forex trading through the use of forex charts you no doubt have encountered dozens of technical indicators available to use including one known as the RSI. Technical indicators are metrics that are designed to predict the future price of a security by analyzing the past price action. In simple English, a technical indicator is a graphical representation on a forex chart that looks at the past and present price to attempt to indicate to you what the future price will be. In this training article, we will be examining one of the most well know and widely used technical indicators known as the RSI :

Relative Strength Index (RSI)

The RSI is mostly used to identify overbought and oversold conditions in the instrument you are trading. Commonly traded instruments are stocks, currency and commodities such as gold and oil. The RSI is calculated as :-

RSI = 100-100/ (1 + RS) where RS represents the average gain of up periods / the average loss of down periods over a session.  Commonly the default time frame for a session  is 14, depicting 14 trading days.

Two horizontal lines are drawn between zero and one hundred : The Overbought Line is drawn at 70, and the oversold line is drawn at 30. (See below)

Unlike Technical traders, fundamental traders do not look at any technical indicators on charts. Instead they rely on data surrounding the stock they wish to measure using PE (price/earnings) ratios, Free Cash flow and many other numbers derived from the Balance Sheets, Income Statements and Cashflow Statements of companies.

A typical fundamental trader would not look at the RSI, but would likely say ”I intend to purchase shares in company X because it has a low P/E ratio compared to it’s peers.”

On the other hand, a typical technical trader would not look at the fundamentals like the above mentioned fundamental trader would. Instead a technical trader might declare ” The price of this stock is overbought with it’s RSI over 70, therefore I will not invest as my technical indicator is telling me the stock is expensive.(See below)

In the above example, classic oversold followed by classic overbought conditions occurred. The price was at the lowest end of a down trend, cheaper than the past price activity, and was correctly depicted by the RSI  as showing an oversold condition under 30. (refer to chart above).  Buyers bought into this low price and by overcoming downward selling pressure, the buyers managed to drive the price of the instrument higher.

Once the buyers got in, the uptrend or upward price momentum continued, driven higher by the buyers until a high price or high price ceiling was reached (indicated by the RSI showing a reading over 70 or overbought conditions). Overbought conditions are where new buyers are reluctant to purchase at such perceived high prices, and investors may look to sell or take their profits after the recent run up in the price. (see chart above)

At this point it should be mentioned that some Technical traders do not believe that 30 and 70 represent sufficient oversold/overbought conditions and will manually adjust their RSI parameters to reflect 20 (oversold) and 80 (overbought). Remember the RSI runs 0 to 100, so such adjusted parameters are also perfectly acceptable. One could say RSI under 30 is oversold and over 70 is overbought, therefore RSI under 20 is extremely oversold and over 80 is extremely overbought.

Use your trading account to back test (look at past history) where the RSI correctly predicted price action at the oversold (30 and under)  and overbought (70 and over) conditions. Using the RSI how would you have determined your entry strategy to enter any of those trades?

So What are the Failures of RSI ?

The RSI itself does the work it was mathematically assigned to do. Where it fails ,  like any other indicator, real market conditions may not always line up or agree with the technical indicators. This is normal. Markets are dynamic and often times quite irrational. Technical indicators can only ‘indicate’ they cannot predict. There is no magic indicator than can predict with certainty when to enter or when to exit a trade. If there was, everyone would use it, and there would be no dynamic market as everyone would buy, and everyone would sell at the same time.

The RSI provides probabilities and very many traders accept the RSI in a very broad sense. In other words, technical traders will say ” I realize the stock is overbought at RSI 70, but I am not saying it can’t go higher – it can!” OR  they may say ”this stock is extremely oversold but it may keep going down until the sector recovers, therefore I will not attempt to call the bottom of this stock even if the RSI is 20.”

The following chart shows the USDJPY first failing to reverse direction on two occasions, then soar continuously despite overbought conditions depicted by the RSI. In other words – Technical Indicator Fail. (TIF) or perhaps more appropriately WTF! as technical traders expecting the price to move down (not up) scratch their heads. (see the three RSI failure conditions on the chart below).

We show this chart of RSI failure (see above chart) as part of your forex training because this is what can happen. Do not rely blindly on any particular indicator. Opinions vary, but it would seem that most technical indicators seem to have a long term success rate at around 49% to 51%.

This is why Pip Asylum Training exists to continue to show the other side of trading, other than the bright flashy articles that only show the indicators working perfectly. As illustrated in this article, we showed the RSI working perfectly (strengths), as well as the RSI failing miserably (weaknesses). Most times however, the RSI is pretty unhelpful for predicting entry points on a chart, as most of the time price movement will hover between overbought and oversold conditions between 30 and 70 (as in the chart below)

CONCLUSION

The RSI is a popular technical indicator that every technical trader should know. Don’t become reliant on it and be aware of it’s good points and wary of it’s failings.

If you enjoyed this training article, please browse through our categories and tags at www.pipasylum.com for more training articles.

 

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