NoaFX Tutorial

5.3 The RSI Indicator

The Relative Strength Indicator (RSI) is another very popular indicator used by the trading market.

An oscillator indicator helps to identify the momentum of the movement of the currency pair, whether it is in a trending upwards or downwards market. More importantly, it helps us understand whether the market is in a state of excessive buying (overbought) or excessive selling (oversold) state.

The RSI Indicator consists of;

  • The Relative Strength Index measuring the strength of price changes
  • The Overbought Zone separator (RSI Value 70)
  • The Oversold Zone separator(RSI Value 30)
  • The Median Zone (RSI Value 50). This is not drawn by default and is illustrated below for explanatory purposes.
What does the RSI Compute?

The RSI measures change of price as to whether it has been a positive or a negative change. The change in the value of RSI is influenced by the change in price between the current close and that of the previous close. A higher price change will result in a stronger RSI value while a lower price change will result in a lower RSI value.

Therefore, an upwards positive price change is calculated by;

Positive Price Change (PPC) = Close of current period – Close of previous period

Likewise, a negative price change is calculated by;

Negative Price Change (NPC) = Close of previous period – Close of current period.

These differences are averaged out using an Exponential Moving Average and divided against each other.

In other words;

Therefore, a division between both the rate of change in the price trends gives a value that is more than 1 which will increment the RSI value, hence positioning the indicator to have an upwards direction.

Or

It gives a value that is less than 1 which will reduce the RSI value, hence positioning the indicator to have a downwards direction.

Trading off the RSI Indicator

As with most oscillator indicators, they measure extreme and median states of the market.

Most traders will like to buy the currency pair when the RSI indicator enters the overbought area and sell the currency pair when the RSI indicator enters the oversold area.

This is quite naturally the trend following or price chasing mentality of the market. However, notice that many of the given opportunities were short lived and had challenges giving enough room for a continued longer trend.

Quite often, it has been observed that the extreme states of the market often turn around to reach the median zone before continuing in the same direction or completely reversing around for a new trend.

Therefore, another way of trading the RSI indicator is the contrarian trading mentality where we can wait for the market to reach its extreme conditions and upon showing signs of slowing down, we take the trade in the opposite direction.


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