Of all of the momentum oscillators that have been developed in the field of technical analysis in recent years, the Relative Strength Index Oscillator or RSI remains one of the most popular and widely employed by technical traders.

Origins Of The Relative Strength Index

Originally created by J.Wells Wilder and published in his book 'New Concepts In Technical Trading Systems, the Relative Strength Oscillator measures the rate of change of price movement on the chart. It is most popularly used by analysts to identify times when the market is potentially temporarily overbought or oversold in relation to its median rate of price gain.

The indicator oscillates between a reading of zero and 100. According to Wilder there were two significant readings that should be noted when trading. A reading of above 70  should be taken as a signal that the market was is currently overbought. Conversely for a reading of below 30 the market should be seen as being oversold.

In both of these instances the expectation is for the market to subsequently reverse from its current overbought reading and return to a neutral level.

Trading With The Relative Strength Index Oscillator

When trading with the RSI indicator it is important to note that it is not primarily showing the trend of the market in the way that a moving average could be used to. Instead it shows the rate of price change within the trend. For example, a trending market can display periods of strong gains and reversals. However these do not fundamentally alter the dominant direction of the trend. The RSI indicator is therefore be used to identify temporary reversals within the greater trend or 'pullbacks' as they are sometimes referred to. These can be considered as times where the market has 'got ahead of itself' or has temporarily 'fallen too far.'

RSI Indicator On Weekly EURUSD Chart

Divergence

While short term reversals in the trend can be signalled by the use of the RSI indicator, it can also be used to anticipate potential turning points in the market. This is when a divergence occurs between the price action on the chart and the reading on the indicator.

Bullish and bearish divergence are the names given to these interpretations.

A bullish divergence is signalled when the price action on the chart records a new low while the RSI reading makes a higher low.

A bearish divergence is signalled when the price action on the chart makes a new high. This however is not confirmed by the RSI reading which makes a lower higher.

Expanded Uses Of RSI

Since the first introduction of the Relative Strength Oscillator there have been subsequent interpretations and expansions to its use.

For instance, rather than using Wilders levels of 70 and 20 to identify extreme market readings, many traders instead prefer to use levels of 85 and 25 as more a reliable method of using the indicator.

One point to consider when trading with the RSI oscillator is that  rather than actually showing a market ready for reversal, it can simply be signalling a prolonged strong move. In this case the market is likely to remain in extreme reading for an extended time.

As will all technical indicators it is not sufficient to simply trade the RSI in isolation. Instead it is preferable that you add the RSI to your trading toolbox as one of a selection of indicators that you can use to help confirm your currency market analysis.