Good day everybody,
Welcome to CryptoGod-1's blog on all things crypto. Today we are going to continue the series on Technical Analysis and why it can be such an important asset for new or experienced traders. In this series I am covering some of the different Technical Analysis and Indicators which can be used to help determine market movement and sentiment when trading. For Part II the focus will be on The Relative Strength Index (RSI).
The Relative Strength Index (RSI)
Developed in 1978 by J. Welles Wilder Jr. in his book titled “New Concepts in Technical Trading Systems.” The RSI is a popular momentum oscillator, a line graph that moves between two extremes, which provides traders with signals on bullish and bearish price momentum. It makes use of measuring the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of an asset, and is displayed as an oscillator which can have a reading from 0 to 100.
Traditionally, users would read the RSI as values above 70 indicate an overbought or overvalued asset, while an RSI reading of 30 or below would indicate an oversold or undervalued asset. Generally these assets will be primed for a trend reversal of pull back in price at these levels, although like all TA, it is not a guarantee.
Calculating an RSI
To calculate the RSI it is achieved by a two part calculation, which begins in the following way:
- RSI (Part 1) = 100 - [100 divided by (1 + average gain divided by the average loss)]
the average gain or loss as part of this calculation is the percentage change in terms of gain or loss during the specified time period. The loss is included as a positive value for the percentage, so even if it had a loss of -10%, that would be represented as 10 in the above formula. When the price is in loss they are included as 0 for the average gain figure, while the opposite is true for the average loss when the prices are increasing. Generally a standard to use is 14 for the period, which when used on a daily chart, calculates the close price of the previous 14 days.
For the second part of the RSI, the following calculation is used, which smooths the result:
- RSI (Part 2) = 100 - [100 divided by (1 + {Previous Average Gain x13} + Current Gain, divided by {Previous Average Loss x13} + Current Loss)]
This will then give you the overall RSI result, and allow for the RSI to be plotted on a line graph. Generally the graph is placed below the candle chart. The RSI rises as the number and size of the positive increases, while it fall when the number and size of the losses increases. Due to the second part of the calculation smoothing the result, the RSI will only get near to the 100 and 0 marks in a strongly trending market.
How to use an RSI
The most standard use of the RSI is reading the line graph with two specific levels. Generally, when the RSI goes above the top level of 70 it indicates that the asset is in an overbought zone and can be seen as an upcoming bearish signal. Similarily, if the RSI goes below 30 then it indicates that the asset is in an oversold zone and should be seen as an upcoming bullish signal.
When trading is in a trend, often the RSI will fall into a band or range. During an uptrend, the RSI will often remain above 30 and frequently hit or go close to 70. During a downtrend, often the RSI remains below 70 and frequently hits or gets near to 30. These are general guidelines which can help traders to determine the strength of a trend and when a potential reversal may occur. If an RSI makes numerous attempts, and fails, to hit 70 on consecutive price swings, then drops to the 30 level, it will generally indicate the trend is getting weaker and could be about to reverse. The opposite is true when a downtrend fails to reach 30 but then goes to above 70. The downtrend has weakened and it could be an indication of a reversal into an uptrend. Trend lines and moving averages can be used to assist the RSI as additional tools for analysis.
An RSI divergence is an indicator that generally a reversal in trend is about to take place. What an RSI divergence is saying is that the indicator does not agree with the price action. This can be spotted by looking at the RSI graph and the candle chart at the same time. When looking at the RSI, if the graph is showing lower highs when the candle graph and price is showing higher highs during an uptrend, then it indicates the momentum has been lost and a reversal is about to take place, meaning a short bet would be considered a good option in this scenario. The same applies when the RSI records higher lows during a downtrend while the candle chart and price is recording lower lows, this can be an indication that the price is ready to chance in direction and a long position would be considered a good option in this moment. These are considered to be an RSI divergence. While not always guaranteed to be correct, generally they can be good indicators if a trader can spot them on the charts.
Below is a sample of an RSI chart along with the associated 15 minute candle chart for ETH. As you can see, the RSI went above the 70 mark when the price rose, and touched it again numerous times. It also crashed below the 30 mark as the price went down, and touched the 30 mark numerous time. While the price was showing little changes, the RSI remained in and around the central mark of 50.
Limitations of an RSI
While the RSI is used to compare bullish and bearish momentum of price in an asset, doing so by displaying the results in an oscillator, its signals can not always be reliable. Generally they are most reliable when they conform with the long term trend of an asset, as in hitting 70 or above in a bullish market. It is difficult to spot true reversals, as they are often rare and very difficult to distinguish from false alarm signals. This is because during a trend the indicator can remain in the overbought or oversold zone for an extended period of time. It is best for distinguishing a trend reversal when the price is going between bullish and bearish, and for new analysts it is best to learn to use the indicator within the context of the prevailing trend to make the most of it.
Conclusion on using an RSI for TA
As a trader, whether it be day trading or long term trading, using the RSI can be very beneficial in understand when is a good time to buy and when to sell. It displays the momentum of an asset, so if a trader sees a high RSI number they should expect a large sell off soon, and vice-versa with a low RSI. The RSI can be most useful in an oscillating market, where the price of an asset is changing between bullish and bearish trends.
As stated above, whether you are experienced or new, Technical Analysis can always be a useful asset when trading. Just remember it is not guaranteed and nobody can predict the future, no matter how certain you believe the patterns to be. It is always just another tool of the trade to help make more informed decisions when trading. It can be easy to get caught in a trap with an RSI when it leaves the over bought or over sold zones, just to re-enter them again after a couple of candles. Always zoom out, if trading on a 15 minute chart check the 1 hour or 4 hour or even 1 day chart to give you a better idea of the overall trend direction. RSI can be good for knowing when traders are buying or selling, and indicating when an asset in trending in a zone or when it is about to enter a trend reversal.
You can find the previous parts to the series here: Technical Analysis - Part I - Exponential Moving Average (EMA)
I hope this post was beneficial and of some use, and I plan on continuing the series with the next instalment focusing on Bollinger Bands (BB). Of course each technical analysis provides different beneficial information, so combining your most trusted and favourite ones can be the best strategy for finding entry and exit points when trading.
Have a great day.
Peace. CryptoGod-1.
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