The Relative Strength Index (RSI) is used by cryptocurrency traders to measure price changes. RSI calculates magnitude and speed of price changes onto a momentum oscillator between zero and 100. It is a popular indicator first 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 market expectations or true value. “Oversold” signals that a coin is trading below market expectations or true value. RSI of 50 acts as the mid-way point, indicating 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. Some crypto traders will use the values of 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
The basic principle is that: 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 due to prices deviating into extreme territories. These extremities act as triggers for buying or selling; traders will buy/enter the market when coins are oversold, i.e., undervalued; or, sell/exit the market when coins are overbought, i.e., overvalued.
“Divergences” are the difference between current price action and RSI. Crypto traders use divergences as “confirmation;” to assess the validity of the current price action, since RSI factors in previous gains/losses. Divergences are found 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 generally occur in the extremities of 70/30. Cryptocurrency traders refer to a “bullish divergence” to describe a correction rising from around the 30 oversold territory and a “bearish divergence” to describe the correction falling from around 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).
A similar confirmation signal is referred to as “failure swings.” But when looking for failure swing signals, you are not taking into consideration the current price action—focus solely on RSI signals. There are two types: a top failure swing or a bottom failure swing. These are identified by looking for either two peaks or two valleys. A bottom failure swing forms when the first RSI drops to the 30 oversold/undervalued level, bounces back up, drops back down, but on the second drop does not go lower than the first valley. In this case, the market is expected to reverse toward a sustained uptrend. 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, the market is expected to reverse to a sustained downtrend.
Wilder’s book and RSI formula is explained in detail here.