RSI Indicator Explained: How Forex Traders Use It

The Relative Strength Index (RSI) is a momentum oscillator developed by J. Welles Wilder Jr. and introduced in his 1978 book New Concepts in Technical Trading Systems. It measures how strongly price has been rising or falling over a recent period and expresses the result on a scale from 0 to 100.

Despite its name, RSI does not compare one currency's strength with another. It compares a market's recent gains with its own recent losses.

How RSI is calculated

The default setting is 14 periods. The calculation has four steps:

1. For each period, record the gain (close higher than the previous close) or the loss (close lower, recorded as a positive number). A period that rises has a loss of zero, and vice versa.
2. Calculate the average gain and average loss. The first values are simple averages of the first 14 periods.
3. After that, update each average with Wilder's smoothing:
   • New average gain = (previous average gain × 13 + current gain) ÷ 14
   • New average loss = (previous average loss × 13 + current loss) ÷ 14
4. Compute RS and RSI:
   • RS = average gain ÷ average loss
   • RSI = 100 − 100 ÷ (1 + RS)

Wilder's smoothing works like a slow exponential average. Each new value has a weight of 1/14, so RSI responds to new price action without jumping around as much as a simple 14-period average would.

Worked example

Assume, for illustration, that after 14 periods the average gain is 15 pips and the average loss is 10 pips.

• RS = 15 ÷ 10 = 1.5
• RSI = 100 − 100 ÷ (1 + 1.5) = 100 − 100 ÷ 2.5 = 100 − 40 = 60

Now the next candle closes 29 pips higher, so the current gain is 29 and the current loss is 0.

• New average gain = (15 × 13 + 29) ÷ 14 = (195 + 29) ÷ 14 = 224 ÷ 14 = 16
• New average loss = (10 × 13 + 0) ÷ 14 = 130 ÷ 14 ≈ 9.29
• RS = 16 ÷ 9.29 ≈ 1.72
• RSI = 100 − 100 ÷ 2.72 ≈ 100 − 36.7 ≈ 63.3

A strong 29-pip gain lifted RSI by only about three points. That damping is the effect of Wilder's smoothing.

Reading RSI

Overbought and oversold

The traditional thresholds are 70 and 30:

• Above 70: often called overbought, meaning recent gains have been large relative to losses.
• Below 30: often called oversold, meaning recent losses have dominated.

These labels describe momentum, not value. A currency pair can remain "overbought" for weeks during a strong bull market, and "oversold" for weeks in a bear market. Selling simply because RSI crossed 70 is a common way to fight a trend.

The 50 line

Some traders use 50 as a trend filter. Readings that hold mostly above 50 suggest bullish momentum; readings mostly below 50 suggest bearish momentum.

Divergence

• Bearish divergence: price makes a higher high but RSI makes a lower high. Upward momentum may be fading.
• Bullish divergence: price makes a lower low but RSI makes a higher low. Downward momentum may be fading.

Divergence can persist through several swings before price turns, and sometimes price never turns. Treat it as a warning to tighten risk or look for confirmation, such as a break of a trendline or a key support or resistance level.

Adjusting the settings

Shorter periods (for example 7 or 9) make RSI more sensitive and produce more extreme readings. Longer periods (for example 21) make it smoother. Some traders widen the thresholds to 80/20 in volatile markets. No setting turns RSI into a forecasting tool; it changes how quickly the indicator responds to past prices.

Common mistakes

• Treating 70 and 30 as automatic sell and buy signals. In trends this can lead to repeated losses.
• Ignoring the trend. Oversold readings in an uptrend can offer better context than oversold readings in a downtrend.
• Relying on divergence alone. It often appears early and can fail entirely.
• Over-tweaking settings to fit past charts.
• Forgetting risk management. RSI says nothing about where to place a stop-loss. Practice combining signals with defined risk in the Trading Simulator.

Summary

RSI measures momentum on a 0–100 scale using a default 14-period lookback and Wilder's smoothing. The formula is RSI = 100 − 100 ÷ (1 + RS), where RS is average gain divided by average loss. Readings above 70 and below 30 show strong momentum, the 50 line can act as a trend filter, and divergence can warn of fading momentum. RSI is calculated from past prices and is not a predictive guarantee. Next, the MACD indicator combines trend and momentum using moving averages.