In this article, we will discuss a very popular indicator in crypto trading, the Relative Strength Index, more commonly referred to as the ‘RSI’.
What is RSI?
The RSI is an indicator that measures the momentum and rate of speed at which the price of an asset is moving at. The core of this indicator is based on the average upward price change vs the average downward price change for a given period of time.
‘RS’, or Relative Strength, is the Average of ‘N’ closes upward divided by the average of ‘N’ closes down. This value is then indexed to 100 by using the following formula.
RSI = 100 – (100/1 + RS)
This leaves us with a value that fluctuates between 0-100. For this reason, this indicator is known as an “oscillator”. The standard period setting for this calculation is over a 14 period based on the periodicity that you have selected to view the asset on. If you are looking at a daily chart it will look back over the last 14 days, if you are on the weekly it will look back over the previous 14 weeks, and so forth.
How to use the RSI Indicator
Overbought & Oversold
Values of over 70 are said to be overbought, and values below 30 are said to be oversold. Applying these criteria in isolation can lead to unfavorable results. Instead, let’s go over some of the better use cases of the RSI to give you an edge when using it.
1- The RSI can remain overbought and oversold for quite some time.
As a matter of fact, in bull markets, we see that Bitcoin often remains in overbought territory without any real relief, and in bear markets, the opposite. The RSI is a momentum oscillator that can be useful at pointing out and making obvious the periods in which price has continued in one direction for an extended time. However, these conditions are times when this would be the norm. For this reason, the RSI might be best used as a signal or warning that goes off for you to start paying attention to the trend and for other signs that it might be getting overextended in either direction. It is not something that should be acted on immediately.
2- Following the previous point
It is important to understand how the calculation and reading of the indicator relates to the price action you are seeing. If price has been moving in a relatively tight range for a prolonged period of time (let’s say for example 14 periods), as you can imagine the RSI would likely be very neutral. Therefore, any impulsive move that follows is going to act as an outlier and throw the indicator to one extreme. As you can imagine, this could be the breakout that leads to continuation. You would not want to look at this as an oversold or overbought reading that is worth fading.
3- The RSI is best applied in its most suitable trading environment
Like a moving average, the RSI is best applied in its most suitable trading environment. For moving averages these are trends, while in the case of the RSI, it is often best used in ranges where a drop-off in momentum at the extremes is one of the telltale signs of expected reversals. Applying the RSI in a strong trending environment is one of the easiest ways to end up acting on false signals. It is quite common for traders to spot divergences in the RSI in a trending market. What’s important to understand is that all trending markets are going to be filled with RSI divergences given the very normal periods of consolidation that occur after impulsive trends. These are always going to read as a divergence in momentum.
How to use Volume to Improve Your Trading? Check out Trading Volume in Ranges and Trends
So, in what ways can we use the RSI effectively?
1- Use it as a bias/momentum context check.
If the RSI is trading over the 50 line, this is when we should look for confirmation in price action that the trend is strong and possibly look for longs. If price is trading below, we will look for confirmation that the trend is weak and look for short opportunities. Often, we see that in a downward or an upward trend the line will act as a loose support or resistance zone and that once reclaimed will be an indication that context has changed regarding momentum. Either it can pick up again for the first time, or suddenly it is now unable to regain steam.
2- Using divergences as a reason for a second look or confirmation of other strengths/weaknesses present.
As we stated above, we need to be careful with this form of application. Often, in hindsight, it seems like a sure thing, but it is usually something that is cherry-picked to look better than it is.
In a Bearish Trend and a Bullish Trend
In the case of a bearish trend, a bullish divergence is when price makes a lower low but the RSI makes a higher low, or in the case of a bullish trend, a bearish divergence is when price makes a higher high but the RSI makes a lower high.
The problem with using it for divergences is acting on it prematurely. For example, let us say the price impulses upward after being sideways for a period of time. Right after the impulse upwards it begins to form a flag the grinds higher. After the initial impulse, the RSI is going to be very overbought. Even though consolidation that forms immediately after is normal, the RSI is going to calculate this price action as having less momentum if it did not continue upward at the same rate of speed as the initial impulse candle. This is always going to print a divergence in a trending market, whether this is a strong uptrend or a strong downtrend.
What we can do with this type of momentum feedback is to use price action as an anchor point. Let’s say that not only do we make a lower high in RSI but now we have lost the high that put in the initial high in the RSI reading, only now could we maybe have a case for a reversal. If anything, this really is just a measure of confirmation.
Like any other indicator, a system can be built around the RSI. It is after all one of the most common trading indicators available.
As a reminder though, as with almost all price action derived indicators, these tools show you what is already right in front of you. All you are seeing is a smoothed representation of the price behavior. Indicators make the finer details a bit more digestible and obvious.
More important than anything else in my opinion, is that you understand how the indicator is calculated, this way you are familiar with not only its strengths but its weaknesses as well. In the case of the RSI, it is an excellent tool, but like all other indicators, it can give a ton of false feedback.
Like anything else, make sure that before you use it, you heavily backtest it and always record data around your trading performance.
By Ryan Scott (@CanteringClark)
Check out our additional technical analyses to improve your Crypto Trading Skills
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