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Determining Price Strength with the Relative Strength Index
Education | 24 January 2014
By: Stuart McPhee
Articles (22) Profile

Business management magnate Peter F. Drucker once said that results are obtained by exploiting opportunities, not by solving problems. For forex traders, looking to exploit potential opportunities is critical, and to that end, the Relative Strength Index (RSI) technical momentum indicator can serve to measure the magnitude of recent gains to losses.

In theory, the RSI measures the internal ‘strength’ of a price and is calculated by comparing the average upward price change with the average downward price change over a set time period. The fewer the number of periods you use, the more erratic the indicator becomes. A 14-period RSI is popular.

The formula for the calculation of the RSI is:

Where:

U = an average of upward price change
D = an average of downward price change

The RSI is plotted between the values of zero and 100, and it generally has reference lines placed at 30 and 70. Note that the RSI can be interpreted a number of ways. One popular approach is to buy and sell when the RSI crosses the reference lines; that is, when the RSI crosses up above 30, it is interpreted as a buy signal, and when the RSI crosses down below 70, it is interpreted as a sell signal.

As the name may suggest, the RSI doesn’t compare the strength of one price with that of another, for instance, an index or benchmark.

An example of the RSI can be seen in Chart 1 which features an hourly chart of the Singaporean dollar (USD/SGD). You will see where the indicator is plotted above the 70 line and below the 30.

Perhaps this momentum indicator’s greatest advantage is in helping to identify divergence. You will notice in Chart 1 how often the indicator generally follows the same path as the price of the USD/SGD. Divergence occurs when the price moves in one direction and the indicator fails to follow.

If, for example, the price forms a higher peak than the previous peak, but the RSI forms a lower peak, this would point toward a lack of strength in the price and it may lead to a fall. This means the RSI may provide an early indication of a likely change in price direction.

The RSI can also be used to identify support and resistance levels and patterns such as heads and shoulders. These patterns may be more obvious on an RSI chart than on the price chart, and they can provide some indication of potential movement.

As indicators are the result of mathematical calculations done on price data and are displayed on charts, by using them, it is possible to anticipate the direction of a price’s movement with a reasonable level of accuracy. However, it should be noted that no indicator is perfect, and no single indicator will be right all the time.

Get a free OANDA demo account to experiment with the Relative Strength Index on our award-winning fxTrade platform.

Stuart has more than 16 years of trading experience under his belt and specialises in technical market analysis of major currency pairs. Apart from being the author of several bestselling trading books, with his most recently released book "Trading in a Nutshell", Stuart contributes to daily newletters and blogs. He also produces articles and videos on the how tos of technical tradings. For more information of Stuart, you can follow him on twitter @stuartmcphee or check him out on Google+.

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