Due to the volatility of the stock and crypto markets, technical indicators provide a guide to plotting entry and exit points. And when learning about technical analysis, it’s impossible to miss the Relative Strength Index indicator. Hence, RSI is a reliable indicator for crypto traders.
In this article, we will learn about the Relative Strength Index – RSI indicator formula, how to read RSI, and what you need to understand about the indicator if you’re involving it in your trading strategy. If you’re interested to learn more about one of the most used momentum oscillators that exists, continue reading!
RSI Indicator Meaning
The acronym RSI stands for Relative Strength Index, which is, in essence, a technical analysis (TA) indicator that measures the strength and velocity of price oscillations. As such, the RSI is a momentum oscillator that examines the magnitude and speed of the market movements.
When applied with standard settings, the RSI indicator takes into account the price of an asset over 14 periods. So if the indicator is applied to a candlestick chart, it would measure the price oscillations based on the previous 14 candles (i.e.,14 hours on hourly charts, 14 days on daily charts, and so forth). Technically, the RSI divides the average gain by the average loss and plots data on a 0-100 scale.
How Is RSI Calculated?
The RSI indicator formula is as follows:
- RSI = 100 − [100/(1 + RS)]
- RS = Average Gain/Average Loss
- Average Gain = Sum of gain per period/time frame (e.g., 14)
- Average Loss = Sum of loss per period/time frame
Trading platforms offer access to RSI and compute the values automatically. Hence, you don’t need to do the calculation. Once you apply it to your trade, the RSI line graph appears below your market charts.
How to Read RSI
The oversold signal in an uptrend is most likely over 30% and the overbought signal is often above 70%. This means that once the RSI is above 30, it is an indication of a bullish trade signal and if it drops below 70, it’s a bearish signal and is likely getting ready for a trend reversal.
This simple guide helps to identify a trend’s strength and to note upcoming reversals. For instance, if the RSI indicator fails to touch 70 during various price swings on an uptrend, yet drops below 30, the trend is weak and might retract lower.
Understanding the RSI Indicator
1. The RSI can remain overbought and oversold for quite some time.
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 the 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. RSI dictates price action.
It is important to understand how the calculation and reading of the indicator relates to the price action you are seeing. If the price has been moving in a relatively tight range for a prolonged period of time, 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. 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 trading.
3. The RSI is best applied in its most suitable trading environment
Similar to moving average (MA) indicators, the RSI is best applied in its most suitable trading environment. For moving averages, these are trends. Meanwhile, the RSI 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.
Closing Thoughts
The Relative Strength Index (RSI) indicator, like all price action – derived indicators, shows you what is already right in front of you. All you are seeing is a smoothed representation of the ongoing price action. Indicators make the finer details a bit more digestible and obvious.
What’s most important is that you understand its formula and how to read RSI. This way you are familiar with not only its strengths, but also its weaknesses. The RSI is an excellent tool, but like all other indicators, it can give a ton of false feedback.
Prior to using the RSI indicator, make sure to heavily backtest it and always record data around your trading performance.
