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The Relative Strength Index is now among the most widely used momentum oscillators when trading cryptocurrency. A momentum oscillator is a mathematical indicator whose values oscillate up and down, reflecting the momentum behind price moves.
The RSI, not to be confused with the relative strength of one market versus that of another, compares the strength of one market’s recent gains to the strength of its recent losses. Values range from 0 to 100 and can be calculated using the formula below.
RSI = 100 – 100/1+RSAverage Gain = Total Gains/nAverage Loss = Total Losses/nFirst RS = Average Gain/Average LossSmoothed RS = [(Previous Average Gain) x (n-1) + Current Gain]/n / [(previous Average Loss) x (n-1) + Current Loss]/nn = Number of RSI periods
Most charting packages default the number of periods to 14. Different values can be chosen, depending on how often the trader wants to generate a trading signal.
The greater the number of periods, the more smoothed the RSI value, and the less frequently trading signals will be generated. Signal reliability increases with fewer signals. Trading signals can be generated either by overbought/oversold readings or by divergence between RSI and price trends.
Overbought and oversold RSI
Most RSI plots include horizontal lines at the 30 and 70 mark, helping identify oversold conditions (RSI < 30) and overbought conditions (RSI > 70). Oversold conditions are those where selling pressure within the market has either reached or is nearing an interim peak.
The price is expected to gradually strengthen, allowing for buyers to take the market higher. Overbought conditions occur where the market has reached or is nearing a peak. The price is expected to correct shortly after.
To avoid too many false or unreliable trading signals, one may want to consider the market overbought only when the RSI exceeds 80, and oversold when it falls below 20.
Generic sell signals are triggered when the RSI falls below 80 (or 70 if more signals are preferred) after having been above 80 (or 70) for an extended period (as a market can remain overbought longer than one can remain solvent), while buy signals trigger after RSI rises above 20 (or 30) following a period below 20 (or 30). Too many premature signals are generated on crosses above 70 (or 80) and below 30 (or 20).
Just as with Moving Average Convergence Divergence (MACD), the slope of RSI can be compared to that of the price for any hints on pending price trend reversals. Positive divergence describes the scenario where the price is sloping downward, while the RSI is sloping upward.
Positive divergence leads to eventual price reversal, where the selling pressure in the market gradually reduces, until buying pressure becomes dominant and pushes the price upward.
Negative divergence describes a rising price, where buying momentum is steadily falling (as reflected by a downward sloping RSI), eventually to be overwhelmed by selling pressure.
With fewer signals typically generated from RSI-price divergence than from overbought/oversold RSI readings, divergence tends to trigger fewer false signals. Rather than trading solely on overbought/oversold RSI readings, a trader could improve his or her strategy by waiting for confirmation signals from price-RSI positive/negative divergence.
This content is not financial advice and should not form the basis of any financial investment decisions nor be seen as a recommendation to buy or sell any good or product. Trading cryptocurrency is complex and comes with a high risk of losing money, particularly if you trade on leverage. You should carefully consider whether trading cryptocurrencies is right for you and take the time to learn how trading works and decide how much money you are prepared to lose.
WRITTEN BYDarren Chu, CFA
Darren Chu, CFA, is the founder of Tradable Patterns, publisher of daily technical analysis on Bloomberg, Thomson Reuters, Factset, Interactive Brokers, Inside Futures, and other partner websites. Before the launch of Tradable Patterns, Darren served as IntercontinentalExchange | NYSE Liffe's country manager for Australia, India, and the UAE, expanding his role to look after Liffe business development in APAC ex-Japan/Korea until his departure mid April 2014. Previously, Darren was with the TMX Group | Montreal Exchange, marketing Canadian futures and options across North America, London, Singapore and Hong Kong. Darren also launched and managed CMC Markets Canada's Chinese marketing and sales team, along with educational offering. Visit www.tradablepatterns.com for more information.