Welles Wilder’s Relative Strength Index (RSI) is one of the most widely used momentum indicators in the foreign exchange markets. There are two basic methods of using the RSI, one for consolidating markets and the other to identify trend reversals. Traditionally, RSI has been used as an overbought/oversold indicator and should be applied in consolidating markets rather than trending markets. At trend reversals there is a common tendency for price-momentum divergences to develop. (See FXS-Divergence)
The problem with RSI is that it has become over-used and fails repeatedly in identifying overbought and oversold conditions even during corrective or consolidating markets. The FXS-RSI is designed to overcome this problem and is more sensitive to price fluctuations.
The chart above displays the USDJPY 4-hour market during February 2003 when the market, while having an upward bias, was quite choppy in nature and would appear to be in the right condition to provide overbought and oversold signals. However, Welles Wilder’s RSI reached overbought only twice during this period and never reached oversold. Indeed, the overbought signals look useful, but the RSI itself did not give any indications of timing to reverse out of any short positions.
On the other hand, FXS-RSI reached overbought on four occasions and oversold on three, providing enhanced indications of when there was risk of a price reversal. While the mere existence of an extreme RSI reading is not sufficient in itself to establish a position, it does highlight the condition and brings awareness of potential reversal.
To demonstrate the more powerful signals that are generated by FXS-RSI, look at this second chart in which even the divergence signals are more pronounced. At the end of the long downtrend in daily USDJPY in July 2002 the standard version of RSI merely recorded oversold but failed to diverge. However, the FXS-RSI provided both oversold signal (although while the market was trending) and a clear divergence. This would have allowed traders to prepare for a break of a downtrend line or previous resistance area. Subsequent to that, the FXS-RSI provided more valid signals than the standard counterpart.