How to Trade Cryptocurrency 101: The Relative Strength Index

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All Cryptocurrency articles are written by our contributor, CryptoNexis

The Relative Strength Index (RSI) is a tool for cryptocurrency traders to measure price changes. RSI calculates magnitude and speed of price changes onto a momentum oscillator between zero and 100. It’s a popular tool developed by J. Welles Wilder in a 1978 book, New Concepts in Technical Trading Systems.

Cryptocurrency traders use Relative Strength Index (RSI) in various ways: (1) assess the momentum of price changes; (2) foresee market reversals; (3) confirm the trend of the market; (4) identify entry and exit positions.

RSI is a two-part formula: first, it averages the gains or losses of a coin over a set of days (standard is 14). The second part of the RSI formula scales the data to an oscillating chart from 0-100.

Generally, when the RSI indicates a number over 70, a coin is considered “overbought;” conversely, when the RSI is under 30, it is considered “oversold.” Each of these points signal that the market is primed for a trend reversal.

How to Interpret RSI

“Overbought” and “Oversold”

“Overbought” signals that a coin is trading above its true value. “Oversold” signals that a coin is trading below true value. A mid-point RSI of 50 indicates consistent movement with past price performance.

The terms can be very confusing, since they both use “over.” It’s helpful to think of “overbought” as overvalued and “oversold” as undervalued. Or, too many bought vs too many sold.

Some crypto traders will vary values and use 80/20 to gauge overbought/oversold levels. Also, keep in mind that some bullish and bearish trends can last a while. In these cases, some traders adjust the mid-way line, up or down, to get a better assessment when a price trend is in an extended side-way movement.

The Basic Principle

To recap: RSI 70 and above signal overbought territory, and RSI 30 and lower signal oversold territory. At these points, the market is due for a correction.

These zones act as triggers for buying or selling; traders will buy when coins are oversold, and sell when coins are overbought.

Divergences

A “Divergence” is the gap between current price action and RSI. Crypto traders use divergences as “confirmation;” to assess the validity of the current price action since RSI indicates previous performance.

Divergences are shown by overlaying the RSI line over the price action line. If trading prices fall to a low point but the RSI does not fall to that same low point, no “confirmation” has occurred.

In this situation, a trader can assume that the price will stall and move sideways, followed by an uptrend. Similarly, when coin price hits a high point but the RSI does not rise to the same level, failing to “confirm” the continued momentum, traders can assume that the price will stall and move sideways, followed with a downtrend.

Wilder explains in his book that divergences occur in the 70/30 zones. Cryptocurrency traders use “bullish divergence” to describe a correction from the 30 oversold territory and “bearish divergence” to describe the correction from the 70 overbought territory.

The chart below is a good example of a bottom failure swing. You can see that the price action (red candlestick wick) is not confirmed by RSI (purple line), indicating a change in momentum (with the added confirmation of RSI 30 territory).

Failure Swings

A similar confirmation signal is referred to as “failure swings.” When looking for failure swing signals, do not look at the current price line but focus on the RSI line.

There are two types: a top failure swing or a bottom failure swing. These are identified by either two peaks or two valleys.

A bottom failure swing forms when the first RSI drops to the 30 oversold level, bounces back up, and drops back a second time. But on the second drop does not fall lower than the first “v” valley. In this case, an uptrend reversal is expected.

Conversely, a top failure swing occurs when the price rises to a peak, followed by a drop, and on the second rise does not go higher than the first peak. In this case, a downtrend reversal is expected.

Wilder’s book and RSI formula is explained in detail here.
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