Relative strength index (RSI) is a popular oscillator that measures price momentum. It was first introduced by the legendary trader J. Welles Wilder in June of 1978 in Commodities magazine (now known as Futures), then spelled out in greater detail in his book, New Concepts in Technical Trading Systems. RSI is applicable for any charted commodity and is used often in forex trading.

RSI compares a currency pair’s average of recent gains against its average of recent losses over a specified period of time, called the look-back period, and expresses that measurement on a scale of one to 100.

Although Wilder recommended a 14-day RSI, the look-back period can be whatever suits the user’s preferences, and the 9-day and 25-day RSI measurements are also popular. Remember that with average-based indicators, the fewer time periods used in the calculation, the more sensitive the indicator; whereas calculations including more time periods leads to a “heavier” and less jittery indicator.

In his book, Wilder specifies five uses for the RSI:

• Calling tops and bottoms in overbought and oversold markets. The RSI often hits this level prior to the actual price. On the 1–100 scale, the RSI is considered overbought (ready to be sold) at 70 and oversold (ready to be bought) at 30. This indicates the market is out-of-balance and remain so forever; however, it is important to remember that the forex trading market can remain in such a condition for rather longer than one might expect.

In overbought and oversold markets, a buy signal is generated when the RSI rises back above 30; a sell signal is generated when the RSI drops back below 70. Both signals generally require confirmation of some sort, such as several doji, or a heiken ashi skating atop or below a moving average envelope.

• Signalling support and resistance levels. The RSI is sometimes a more sensitive indicator of these important forex trading levels than the price action itself. An RSI above 50 is considered bullish; below 50 is considered bearish.

• Forming chart patterns, such as triangles or head and shoulders. Again, sometimes the RSI illustrates these more clearly than the price action itself.

• Diverging from the price action as a signal of a possible reversal. This occurs when the price of the currency pair reaches a new high or low, but the RSI does not surpass its previous high or low. In this situation, it is usually the price, rather than the RSI, that corrects, reversing its trend.

• Confirming the reversal with a failure swing. After divergence between the price and RSI is observed, and following the price correction, the RSI tends to reverse itself and break its previous opposite position, either support or resistance. As an example, see the chart below.

This is the EUR/USD 30-minute chart on 6 December 2007. Note the divergence between the price, at a lower level than previously reached, and the RSI, which has not dropped quite as far (all illustrated by white circles). Following that point, the trend reversed, and the price and RSI penetrated that day’s resistance levels (blue lines). When the RSI breaks its resistance, it’s considered a market-entry signal.