Relative Strength Index (RSI) for Bitcoin, Forex or Stocks
Going against the trend is how many big time investors like 'Michael Burry' and 'Steve Eisman' made their millions...
However, to make money doing this you need to be sure about your bias and have the fundamentals and indicators to back you up, one of the tools you can use is the Relative Strength index or RSI...
In this article I will cover: (What you'll learn about the RSI indicator)
How to use the RSI index to Trade Crypto (Bitcoin Strategy)
How do you know if a market is oversold or overbought?
To answer this question, we first need to figure out what overbought and oversold assets and markets actually are…
When traders call a stock oversold, let’s just use Tesla as an example, it simply means that they believe that there is a large amount of trading days where the price of TSLA has fallen, this run of consecutive lows would indicate that there are a lot of people selling the asset at the same time, meaning that they are leaving themselves exposed to a potential ‘short squeeze’.
The opposite is also true for when traders call tesla Overbought, except in this scenario there are consecutive higher days for the asset, indicating that there is lots of momentum and money being pumped into buying Tesla stock.
A trader like ‘Charlie Munger’ would look at this information indicating that there is a ‘bubble’ of optimism around the stock and there is a potential reversal on the horizon.
But how do traders measure whether a stock or currency is overbought or oversold?
It may seem like there would have to be hours of research and constant data monitoring to determine this, but the answer comes in a set of 3 lines at the bottom of your price chart, available to anyone on ‘TradingView’…
These 3 lines are also known as the Relative Strength Index or RSI for short!
What is the relative strength index (RSI meaning)?
The Relative Strength Index (RSI) is essentially a momentum indicator. It measures the speed and change of price movements of any given asset in real time. The RSI index moves between 0 and 100. It provides traders signals about bullish and bearish price momentum, and it is often plotted beneath the graph of an asset's price.
You may hear the RSI index being described as an ‘oscillator’, this just means that it is a line graph that moves between two extremes (in this case 0 and 100).
The indicator was originally developed by J. Welles Wilder Jr. and introduced in his seminal 1978 book, "New Concepts in Technical Trading Systems."
Now the RSI index is used by millions of retail traders and professional analysts alike and is a staple for a lot of technical analysis strategies…
One of the main reasons for its popularity is because of its consistency and reliability, because it is based on past price movement the longer an asset has been around for the more data the RSI index has to measure and therefore the more accurate it becomes!
What does the Relative Strength Index tell you?
Like any indicator the RSI index is built to tell traders when they should either buy or sell an asset…
Traditionally the RSI index is considered overbought when above 70 and oversold when below 30. Signals can be generated by looking for divergences and failure swings. RSI can also be used to identify the general trend.
These traditional 30 and 70 levels can also be adjusted if necessary, to better fit the asset. For example, if a security is repeatedly reaching the overbought level of 70 you may want to adjust this level to 80.
This is what it looks like when an asset is overbought.
This is what it looks like when an asset is oversold.
When an asset is overbought on the RSI then as a trader you will look for opportunities to short (sell) that asset, and vice versa…
It all comes from the concept that when conducting your technical analysis with the RSI you should focus on trading signals and techniques that conform to the price trend at the time.
In other words, using bullish signals when the price is in a bullish trend and bearish signals when a stock is in a bearish trend will help to avoid the many false alarms the RSI can generate.
Why do traders use the RSI?
As I mentioned earlier the RSI index is popular because of its reliability…
The longer an asset has been around the more reliable the RSI indicator will get, but its reliability is not it’s only strong suit…
The 30 and 70 levels are the recommended levels however every asset is different and also so is every trader, traders with huge risk appetites may even adjust their overbought or oversold levels to a tighter margin, maybe 40 and 60…
Or if on an asset such as GBP/USD, for example, if you noticed the asset would drop every time it hit the 60 level, you could use that as your new overbought level.
Obviously, this is up to the trader and I would always recommend sticking to the 30 and 70 levels, but this gives you an idea of why traders like the RSI indicator.
The Relative Strength Index Formula (RSI Calculator)
Now you know what the RSI Index indicator does let me explain to you how it was originally created and how you can even create your own Relative Strength Index!
The RSI is a two part calculation, we start with a simple formula...
The average gain or loss used in the calculation is the average percentage gain or loss that the asset has experienced historically. The formula uses a positive number for the average loss.
The standard is to use 14 periods to calculate the initial RSI value. We will explain what 14 periods means in more detail next but put simply this number indicates how many days, weeks or months of historical price action the RSI indicator is using.
For example, if I where looking at a daily chart, a period of 14 days would mean that my RSI indicator would be looking back 14 days to give me my RSI Index reading.
Now to apply this to a real life scenario, this will take a bit of imagination so bear with me...
Imagine the market closed higher seven out of the past 14 days with an average gain of 3%. The remaining seven days all closed lower with an average loss of -0.5 %. The calculation for the first part of the RSI would look like the following expanded calculation:
That would give us a value of 89.36!
Now for step 2, here's what that formula would look like...
The Best RSI Indicator Settings for TradingView
Most beginner traders struggle with the actual setup of indicators, here I will show you how to set up your RSI indicator on TradingView and what all the settings actually mean…
Inputs
Length - The time period to be used in calculating the RSI. 14 days is the default.
Source - Determines what data from each bar will be used in calculations. Close is the default.
Style
RSI - Can toggle the visibility of the RSI as well as the visibility of a price line showing the actual current price of the RSI. Can also select the RSI's colour, line thickness and line style.
Upper Band - Can toggle the visibility of the Upper Band as well as sets the boundary, on the scale of 1-100, for the Upper Band (70 is the default). the Upper Band's colour, line thickness and line style can also be determined.
Lower Band - Can toggle the visibility of the Lower Band as well as sets the boundary, on the scale of 1-100, for the Lower Band (30 is the default). the Lower Band's colour, line thickness and line style can also be determined.
Background - Toggles the visibility of a Background colour within the RSI's boundaries. Can also change the Colour itself as well as the opacity.
Precision - Sets the number of decimal places to be left on the indicator's value before rounding up. The higher this number, the more decimal points will be on the indicator's value.
How do you use Relative Strength Index (RSI Trading)?
The traditional RSI trading method consists of waiting for the RSI indicator line to move into the overbought or oversold regions (70-30) and then activating your order based on where the RSI is, here is an example below of what that would look like…
There are 2 ways to use the RSI method however, and the second method will take a bit of explaining…
The second method is called “RSI Divergence” and it basically means that you trade using the RSI index as a more reliable source of information than the actual price of an asset.
Don’t worry, if you don’t understand, let me break it down…
Divergence in trading means the price of an asset is moving in the opposite direction of a technical indicator, such as an oscillator, in this case the RSI. Divergence warns that the current price trend may be weakening, and in some cases may lead to the price changing direction. ‘read more here’.
The RSI divergence method effectively means that if price is moving up, but you see a dip In the RSI indexes oscillator then you should rely on the RSI index over price, this is due to the fact that price will more often than not correct itself and follow the RSI.
This is not a coincidence however, due to the fact that the RSI is formed using past price data it can be seen more reliable as the price chart itself, this is due to the fact that price can be manipulated and reactive.
If a big investment bank where to dump billions of dollars into a stock the stock would rise but the RSI might not, it might even fall, this could tell you as a trader that eventually this bullish momentum will end and price will reverse, then its all about ‘timing your entry well and using stop losses that don’t get hit’, and making lots of money!!
Because price is so malleable the RSI divergence strategy has helped a lot of traders take not only control of their strategy but also not getting caught up in ‘FOMO’.
FOMO can be very dangerous or retail investors especially, it can lead to huge losses however the RSI divergence strategies can help you see a bigger picture trend in an asset, looking at avoiding the short-term hype and helping you stay ahead of the curve as a trader.
This is the RSI divergence method, here is an example of RSI divergence in action…
How to use the RSI Index to Trade Crypto (Bitcoin Strategy)
The RSI Index is not just exclusive to Forex or Stocks, you can also use it in your Crypto Trading Strategy...
This is an example of the RSI Indicating that Ethereum was oversold, then we saw a sharp drop in price.
Again here is a prime example of the power of the RSI indicator working on BITCOIN, price entered the overbought zones in the highlighted boxes and then in a matter of days there was a sharp drop in price which actually continued on for another week!!
This would have been the result of your trade...
Is the RSI a good Indicator?
Whether an indicator is good or bad is very subjective, it all depends on the individual trader and their personal preferences.
The RSI index has been around for a long time and is known for it’s reliability, as we have seen in the previous sections the RSI can help traders both professional and retail make good investing decisions and almost acts as a ‘leading indicator’ when you add in the divergence strategies.
Personally, I use the RSI indicator as part of a wider trading plan and even though it is a key part of my strategy it does not make up the whole thing.
The Best RSI Indicator Strategy
The RSI is at its most effective when it is used in the Global Macro strategy used by many professionals and private investors worldwide, this strategy combined aspects of macro-economics and fundamental analysis with the technical analysis methods of the average retail investor to gain real time and detailed biases on the strength of different economies.
As you can see from the diagram above that the RSI is part of the optimisation section of the Global Macro strategy, optimisation refers to the timing of your trades, and this is where the RSI comes into it's own.
As it uses past price data it is extremely good at allowing Global Macro Investors to time their trades well especially when a currency is in the oversold or overbought regions.
Conclusion
I hope you enjoyed this article explaining the RSI, if there is anything you think we missed please comment below and we will surely help out…
The RSI is a huge part of a lot of trading strategies, and even though it is very reliable it shouldn’t be the be all and end all of your strategy…
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