Relative Strength Index In Forex Trading

Relative Strength Index

What is forex trading?

Before understanding the role of the relative strength index and its relatable in the forex trade, traders must know what forex trading is? So, let’s first know about forex trading and how it works?

Forex market is the online trade of international currencies among the traders of various countries. The currencies are exchanged for a benefit and to earn higher profits. When the traders buy and sell the currencies for incurring profits, it is termed forex trading. Forex stands for foreign exchange market, so the foreign currency is exchanged among traders, investors or business houses to earn profits from currency values in the financial market. 

The process of buying and selling, and speculating over the currency is called forex trading. 

Relative Strength Index (RSI)

Welles Wilder developed the RSI to measure the trading instruments price’s speed and velocity within a specified time. Being a technical indicator of the price momentum, it is widely used in the world. It has been used over different markets. First, we’ll understand its use in the forex market. 

RSI is a technical tool of the forex market used to identify the situation of overbought and oversold securities. Thus, suggesting momentum investing using the oscillator. The oscillators are the line graphs between two extremes of the market. The extremes of the relative strength index lie from zero to a hundred, and the RSI is calculated by considering the price fluctuations. If the RSI value is over seventy, then it is a signal of an overbought situation. That means the security is overvalued in the market. In contrast, if the RSI values less than thirty, it’s an indicator of oversold situations; hence, the security is undervalued. 

Traders of the forex market should consider RSI for deciding the entry and exit but also use other indicators to have a precise and accurate decision. 

RSI has other factors like relative strength analysis that helps traders know the price movements and make predictions. 

What is Relative Strength Analysis?

Relative strength analysis is the technical report of the forex market. It helps traders, investors, brokers, businesses and other corporations of the market to make decisions based on the report. In addition, the technical data available through the market study guide the forex market investors about the market changes and price movements—the market fluctuations, further aid investors to predict market movements in the near future.

In the forex trade, which is one of the world’s most liquid markets, relative strength analysis tells about the ongoing trends of the market that would help brokers and traders invest accordingly. Traders can even know about the entry and exit of the forex market. With such reports, it could be decided when traders should buy and sell to earn high profits. Moreover, financial institutions, traders, etc., can know about the market dynamics, which market is earning and which one is at a loss. 

Relative strength analysis, thus, compares forex currencies and exchange rates to get accurate information about the trade and trend—a useful analysis tool for forex traders. 

Defining Analysis

Analysis of any market factor refers to research on that area to better understand the forex market’s trend or direction based on the technical and fundamental data. Technical data studies the price movements, and changes whereas fundamental analysis relate to mathematical issues like corporate earnings, economic calendars and formulas etc. 

RSI Indicators

The relative strength index (RSI) has indicators or measurements set to identify the trend or change of the price. Here, we have listed the indicators that would help the forex market forecast and understand the trends and price changes. 

  • If the reading of the RSI on the chart is below 30, this indicates an oversold position and the price value of securities is increased. 
  • If the reading of RSI is more than 70, this indicates an overbought position and the price value of securities is decreased. 
  • The movement of the RSI is from below the centre line to above then it is termed a rising trend. 
  • Similarly, if the movement of RSI is a crossover from the centre line to below is an indicator of a falling trend. 

Relative Strength Index Calculation

The calculation of the data through a formula is a difficult task. One has to be good at maths to do all this. But not every trader would be a mathematician so, to help them out, the trading platforms have an automatic calculation of RSI. First, it is important to know the formula and calculation process to understand the formulas and how the analysis works. Here’s the formula of RSI: 

RSI = 100 – { 100/ (1+RS)} 

(RS stands for relative strength)

RS = Average gain / Average loss

Thus, RSI measures the relative strength of security in the forex market. The slope of RSI is directionally proportional to the velocity of change, and the distance travelled is comparable to the magnitude of the move. 

Relative Strength

Relative strength is a strategy used for trading in the market. It is used in momentum investing and identifying the value of securities. Thus, it focuses on investing in the currency pair that has performed well in relation to the market or the benchmark. Relative strength works to buy the currency at a high price and sell it at a much higher price. Therefore, the traders of the forex market who use relative strength indicators believe that the trend that is present currently will continue for an extended period of time and will make positive returns. However, there may be a trend reversal that could lead to loss. 

The relative strength performs better when the market is stable, and more minor changes have good profits. 

Functions of Relative Strength Index

Relative strength index plays a significant part in the forex trade and the following functions to help traders predict price movements. We have mentioned below following five functions of RSI for better performance of forex traders: 

Trendline Application

A trendline is the application of the lines on the chart for understanding the relative strength index. Trendlines and the closing chart both go hand in hand, thus, making it quite difficult to analyse which one is the trendline and closing chart. The trendline is applied in the closing chart; it may be upwards or downwards, whatever direction it is. 

In addition to this, the closing trendlines are also applied on the closing chart in the same manner. 

The trendline indicates the price movements before and helps in analysing the future actions. RSI trend lines break three-four days prior and give advance signals to the traders about the reversal. 

Pattern Breakout

Patterns in the formation of a chart is a process that helps to make decisions. Patterns may be in the form of reversal or continuations; however, they always have a breakout point. The breakout is visible in advance through the RSI because relative strength considers the security for a specific period of time. In RSI, the breakout appears two to three days in advance and could follow the price changes. 

Advance Breakout and Breakdown

The OBV indicator is used to analyse the concepts of advance breakout and breakdown. The advance breakout occurs when RSI breaches the previous top signal, whereas price has not breached the previous top price. The phenomenon makes it an advanced signal of the price change that would follow the trend. 

In advanced breakdown, the opposite happens where the indicator breaches the previous bottom and the price has not reached the previous bottom or is still below that. The indicator of change that price breakdown is visible through this, and the corrections also take place. The signals of RSI help in early decisions of the changes. 

Role of 50 

The middle 50 line of the RSI plays an essential part in making forecasts. During the bullish period, the price stays above the 50 lines, and in contrast, it faces strong resistance from the middle 50 line in RSI during the bearish phase of the forex market. However, traders must analyse daily charts on bigger timeframes to have correct predictions as there may be difficult and tricky situations. 

Line 50 of RSI acts as a trend changer in the market analysis. 

Failure Swing

The failure swings in the relative strength index are the advanced techniques that show the trading RSI divergences. The relative strength index divergence of price and indicator diverge from each other, indicating loss of momentum in the ongoing trend. Similarly, when RSI failure swing occurs, the same thing happens with confirmation of trend change on the fail point of the break. 

Traders should always wait and analyse these failure swings properly to have good trade decisions. There are types of failure swing; failure swing top and failure swing bottom.

The bullish failure swing is formed when the relative strength index moves below 30 that is the oversold condition. When it bounces back above 30, it is called pull back; this holds the above 30 positions and then breaks higher than the prior one. Similarly, the bearish failure swing is formed when the relative strength index moves above 70; that is the overbought situation. It pulls back and then breaks at the lower point. 

Overbought and Oversold Conditions

The overbought and oversold conditions of RSI helps traders to make investment decisions in the forex trade. The trendline of the RSI aids the traders to decide on the overbought and oversold situations. When the RSI line moves above the horizontal line of 30 reference levels, that is the indicator of the bullish level. Similarly, when it goes below the 70 horizontal lines of RSI, it is the bearish level and its indicator. However, due to the frequent movements of the securities of the forex market, the values of 80 and 20 are also used for the overbought and oversold conditions of the forex market. 

Relative Strength Index Divergences

Divergences in the RSI are the signals of a potential reversal of trends in the market. The situation occurs as the directional momentum does not confirm the price. The bullish divergence incurs when the forex security goes lower, and the RSI forms a higher low. The RSI does not confirm low and shows the strength of the momentum. In contrast, the bearish divergence is formed when the security is higher, and RSI goes lower high. Here, RSI does not confirm the new high and shows the weakening of the momentum. 

However, using the divergence as trading signals, traders should be well aware that they mislead them. In the strong trends, the divergence signals are wrong sometimes. 

How to use Relative Strength Index (RSI)?

Traders of the forex market should know how they use the relative strength index in the trade to have beneficial outcomes. Although, it is not tranquil due to the graphs, trends, charts, lines, formulas and various terminologies. But, once understood there use is straightforward. RSI helps to use the potential ups and downs of the forex market depending on the overbought and oversold situations. So, let’s quickly understand the use: 

Overbought Signals: Primarily, the RSI values at 70 or above and indicates the security if it is overbought or overvalued. Also, it may signal the pullback considering it as the sell indicator. 

Oversold Signals: In oversold signals, the RSI values 30 or less and signals that security is undervalued and the price of the security is strengthened. Traders find this situation as an opportunity to buy the securities and invest more to earn higher profits in future. 

Conclusion

Relative Strength Index has been an effective strategy and indicator of the forex market. As the forex market is liquid and volatile, such indicators make trade predictable and convenient. With trusted brokers like ROInvesting and TradeATF, traders can use the indicators through their trading platform facilities. The straightforward use of these would help traders in analysing the market more thoughtfully and perfectly. They can in advance have all the required trend analyses to make correct decisions. The relative strength analysis, divergence, and other relative strength factors are pretty important to have an accurate report of the technical changes in the market. 

Thus, the Relative Strength Index is an essential tool for forex market trading and analysis.

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