How Do you use the RSI indicator in Crypto?
So you are getting into crypto trading and you need to learn proper technical analysis in order to become a successful trader. In this guide, we introduce one of the most popular trading indicators, the Relative Strength Index and put it in the content of trading crypto. While there isn’t a big difference between trading crypto and traditional assets; the RSI comes as a handy tool for both markets.
The RSI or Relative Strength Index is a momentum indicator for conducting technical analysis across asset markets. The indicator tracks down the speed and magnitude of price fluctuations across a given asset’s price so as to determine whether the asset is oversold or overbought.
A standard RSI reading is displayed on a standard oscillator in the range of 0 to 100.J. Welles Wilder Jr, a mechanical engineer popularly known for his work in technical analysis invented the RSI and introduced it in his 1978 seminal book, “ New Concepts in Technical Trading Systems” There are also other functionalities associated with the relative strength index besides indicating overbought and oversold securities. These include pointing out-trend reversals, corrective pullbacks in the price of an asset or signalling traders when to either buy or sell. A Relative Strength Index reading at 70+ shows an asset is within overbought conditions. While a reading below 30 shows the asset is in the oversold region. There is also a small chance of the RSI being used to identify the end of a bear market. For example, past crypto winters have witnessed a drop in the Bitcoin RSI to the oversold region. The Bitcoin RSI dropped to 16, signalling the lowest moment of the previous bear market. However, we are going to look at ways of identifying the end of a crypto winter in another article, where we will explain this in detail.
Meanwhile, let’s look at how the RSI works. Remember the Relative Strength Index is a momentum indicator. Therefore, it aims to compare the strength magnitude of a financial instrument during an uptrend with the magnitude of the same instrument during a downtrend. When the index relates this comparison to the current price action, traders and analysts get an understanding of how an asset will perform in days to come. Traders make better-informed trading decisions when they combine the use of the RSI with other versatile technical indicators. There are at least 25 major indicators.
Calculating RSI Step 1 using its standard formula
RSI (Step 1) =100 – [1001+ Average gainAverage Loss]
Average gain and average loss in the above formula represent the average percentage gain or loss throughout a look-back period. The formula takes into account a positive value for the average loss. When calculating average gain, periods, when assets have lost prices, are counted as zero. When calculating average loss, periods, when assets have gained prices are counted as zero.
The initial RSI value is calculated using 14 standard periods. For instance, the last 14 days saw the market close higher 7 times, and experienced an average gain of 1%. The rest of the remaining 7 days closed lower with a -0.8% average loss. The first RSI calculation will take the following equation:
55.55 =100 – [1001+ 1%140.8%14]
Once your first RSI calculation has adequate data from 14 periods, it’s time to move forward to the second calculation. The main reason we have multiple calculations is to smooth the plotting as the Relative Strength Index nears point 100 or point 0 during a strong market trend.
Calculating RSI Step 2 using its standard formula
RSI (Step 2) =100 – [1001+ (Previous Average gain x 13) + Current Gain (Previous Average Loss x 13) + Current loss]
How to Plot the Relative Strength Index
Analysts can plot the RSI indicator beneath the price chart of an asset once they have calculated the RSI. The indicator rises with an increasing number of days when the price goes up. A fall in the indicator occurs with an increase in the number of days when the price goes down.
Take, for example, the chart shown here:
The Relative Strength Index (RSI) can still remain within overbought conditions for an extended period while the asset is undergoing an uptrend. At times, the indicator could also remain within oversold conditions for an extended period even when the asset is undergoing a downtrend. Both of these incidents become a nuisance for beginners to understand, and sometimes confusing. Good thing is that with time and experience in using the RSI indicator, one gets to understand how to implement it depending on market conditions.
How to use the Relative Strength Index with Trends?
Modifying RSI Levels to Fit Market Trends
An asset’s primary trend is vital when understanding Relative Strength Index readings. Take for instance a proposal by Constance Brown that outlined that oversold conditions in an uptrend have an RSI reading higher than 30. On the other hand, overbought conditions during a downtrend are lower than 70. Therefore, this is why you are more likely to see the RSI peaking near 50 instead of 70 during a downtrend. And hence, it would occur to traders as a more reliable bearish signal rather than a bullish signal.
Some traders prefer creating a horizontal trendline between the 30 – 70 range during a strong market trend so as to clearly identify the overall trend and its strengths. But it is not a compulsory procedure to modify overbought or oversold RSI levels whenever the price of an asset is following a long-term horizontal trading range.
However, note that the RSI indicator is strongly regarded in trading ranges as compared to trending markets. In fact, traders have to use the indicator in combination with other indicators to make the readings more reliable.
Use Buy and Sell Signals That Fit Trends
It is important to use a trading indicator, technique or signal that conforms to the current market trend. For example, use a bullish signal for a bullish trend and a bearish signal for a bearish trend. This will prevent traders and analysts from generating false price alarms, which the RSI is capable of during trending markets.
Overbought or Oversold
A bullish RSI signal take place when the RSI crosses 30. A bearish signal takes place when the indicator crosses 70. In other words, an RSI value of 70 and above can be interpreted as an asset within overbought conditions or an asset becoming overvalued. This means that the asset could undergo a corrective price pullback or trend reversal at any time. On the other hand, an RSI below 30 shows an asset is within oversold conditions or has been undervalued by the market. Therefore, traders should prepare for a trend reversal anytime.
Think of overbought conditions as an asset trading at a price way above its true value. This loosely translates to the price not trading within a range it should be. When traders see this reading, they are most likely to sell their positions for that security.
The same applies to oversold conditions. An asset is trading at a price below its true value. Hence traders can expect a price correction, that could see the price soar higher. This means the trader will either hold on to their position or buy more of that asset.
Interpretation of RSI and RSI Ranges
RSI readings are likely to drop into a range/band during market trends. For instance, the RSI tends to float above 30 and frequently touches 70 when the price is in an uptrend. Throughout a downtrend, it is rare to have the Relative Strength Index above 70. It mostly hits 30 or below as it alternates.
If traders pay attention and completely understand the RSI indicator, they will be in a position to easily determine the strength of a trend; as well as spot potential price reversals. For example, a weakening trend could be signified by the RSI failing to reach the 70 value for a consecutive number of swings throughout an uptrend, and then the value suddenly drops below 30. This is a clear indication that the trend is reversing lower. Likewise for a downtrend, where the RSI is unable to hit 30 and below for a consecutive number of swings and then the indicator swings to 70 and above. This shows the downtrend has weakened and the price could be headed for a reversal to the upside.
Example of RSI Divergences
RSI Divergences takes place when the price of an asset moves contrary to the RSI. For example, a chart could show a change in momentum prior to a corresponding price fluctuation. There are two types of divergences, a bullish and a bearish divergence.
A bullish divergence takes place when the Relative Strength Index shows an oversold condition, which is followed by a higher low that indicates lower lows on the price. This is a clear indication of rising bullish momentum, and only a break above the oversold region will trigger a new long position.
A bearish divergence on the other hand takes place when the Relative Strength Index shows an overbought condition, followed by a lower high that seems to indicate a higher high on the price.
The chart below indicates a bullish divergence that took place when the RSI formed a high low as the price of the asset formed a lower low. This is an example of a valid signal, however, divergences are a rare occurrence particularly when an asset has been stable for a long period of time. Meanwhile, learn to use oversold and overbought readings as they come in handy when identifying potential trading signals.
Disadvantages of the RSI
The Relative Strength Index draws a comparison between bullish and bearish momentum and displays the computation on an oscillator. The display chart lies below the price chart. Price momentum is not good for determining short-term price changes. Hence, the RSI is only reliable when the signal you are looking for conforms to a long-term trend.
Valid reversal signals are hard and rare to come across. It is also difficult to distinguish between a true reversal signal and a false alarm. For instance, a bullish crossover coming before a sudden price decline is one false positive alarm. While a false negative alarm would take place when there is a bearish crossover and the price of the asset swings upwards.
When the asset has strong momentum, it is possible for the RSI to stay overbought or oversold for a significant amount of time. Hence, making it uncomfortable to rely on the RSI to determine price changes. This means that the RSI is only vital when determining trading ranges in oscillating markets.
RSI Frequently Asked Questions
What should I do when the RSI is low?
Based on the idea that an asset is in the oversold region and the price could rebound anytime, most traders prefer to use a low RSI reading as a buy signal. However, it is crucial to combine this signal with other indicator readings and get more context of the prevailing market condition. This is because, for example, the asset might continue trading in the oversold region for a significant amount of time throughout a downtrend. Therefore causing traders to delay buying the asset even when they had the intention to buy. Such traders could also be waiting for another technical indicator to confirm the bullish signal.
What should I do when the RSI is high?
A high Relative Strength Index (RSI) means that the price of an asset is trading in overbought conditions, and could drop at any time. Therefore most traders use a high RSI reading as a sell signal. This is because the RSI is in essence an indicator for determining overbought and oversold price conditions.