In a previous article, we covered the basics of margin trading: position sizing, decision making and the importance of having a stop-loss. In this article, you will learn the basics of indicators by focusing on one among the most important, the Relative Strength Index (RSI) indicator.
What is an indicator
An indicator is a piece of information that you use to make sense of a financial chart in order to predict the hypothetical outcomes. Fundamentals (the company runs out of money, the user base is growing, etc.), rumors & news (acquisition, new features, etc.) or various other events (important conference, marketing campaign, etc.) can be useful indicators that will guide your trading habits.
There is a specific category of indicators that is solely based on abstract data resulting from the charts themselves that are called technical indicators. Technical indicators are mathematical calculations and algorithms that use charts data (price, volume, etc.) to provide additional information about the market behavior. Technical indicators do not predict future trends, but they give, in a simplified way, useful information on how markets behave, whether they have anomalies or whether particular tendencies are emerging.
What is the RSI
The Relative Strength Index (RSI) is an unavoidable technical indicator which tells you with a value between 0 and 100 how much the current price is unusual compared to how it used to be recently. We say that it is a momentum indicator because it relates to the “strength”, or rather rate-of-change, of the price movement.
The RSI is a quite easy indicator to calculate. So easy that you can even make your own RSI calculator in an Excel spreadsheet. First, you need to calculate the RS, which is the average gain over a specific time window divided by the average loss over the same time window. Then, you simply use this formula: RSI = 100-(100/(1+RS)). The closer the RSI value is to 100, the more likely the asset is to be overbought. The closer the RSI value is to 0, the more likely the asset is to be oversold.
Why using the RSI: basic use case
You refresh and record Bitcoin’s price every minute. The price is stable but you want to be aware when something happens so you can get ready to buy or sell. You could code an alert that prints on your screen “BITCOIN IS MOVING” when the price suddenly move above +1% or below -1%. But it could be a volatile passage composed by a succession of +1%, -1% or even +2%, +3% then -4%, -2%, etc… That’s not good because you need to know when the price is taking off or dropping for real. That’s when the RSI comes into play. You can set a period of 14 cycles (common parameter), meaning that you will calculate the average gain and loss for the last 14 minutes. Let’s say that you end up with 8 positive changes and 6 negative changes. When you sum them all you get Sum of Gains = 25$ and Sum of Losses = 18$. So, Average Gain = 25/14 = 1.79 and Average Loss = 1.29. You then use the formula: RSI = 100-(100/(1+(1.79/1.29))) = 100-(100/(1+1.39)) = 100-(100/2.39) = 100-41.84 = 58.16.
You got your first RSI, and it shows a value close to the middle (50), meaning that there is nothing to worry about. We usually say that the asset is starting to be overbought when it goes over 70 and that it is starting to be oversold when it goes below 30. What happens next is up to you. Maybe it is a good idea to buy when the RSI crosses 30 or 20… or 10? It is your duty to tweak the RSI so it fits your needs and that’s also sometimes when other indicators come into play. That being said, it is possible to optimize the usefulness of the RSI by focusing on the most likely fruitful scenarios. Below, we present to you the two most popular patterns that you should look into before integrating the RSI to your trading strategy.
Sometimes the RSI trend doesn’t follow the price trend: the price goes up while the RSI goes down or the price goes down while the RSI goes up. It happens for various reasons and we call those situations RSI divergences. There are two types of RSI divergences. Bearish divergences occur when the price records a higher high while the RSI forms a lower high. Those divergences are called bearish because we assume that, following a contradiction (the price unexpectedly contradicted what was supposed to be a downtrend/correction), the price is more likely to converge back with the RSI. Since the RSI is initiating a downtrend from the top (overbought zone), it is more likely to continue its way to the mean/bottom.
Bullish divergences occur when the price records a lower low while the RSI forms a higher low. Those divergences are called bullish because, as for the bearish divergence, we assume that the price is more likely to converge back with the RSI after the contradiction. This time, the RSI is initiating an uptrend from the bottom (oversold zone), so it is more likely to continue its way to the mean/top.
Positive & Negative Reversals
Since it is a divergence based set of analytical rules, P&N reversals kind of complete the classical RSI divergence tool. We previously saw that a diverging price is more likely to follow back an initiating RSI trend. However, we assume that the opposite scenario might occur if the divergences show up when the RSI trend is measured outside of the overbought/oversold zones, more toward the mean.
A positive reversal occurs when the price records a higher low while the RSI forms a lower low. The RSI downtrend is “reversed” and converge back with the price uptrend. Note that, in the reversal scenario, it is the RSI which follows the price trend and not the price which follows the RSI trend.
A negative reversal occurs when the price records a lower high while the RSI forms a higher high. The RSI uptrend is reversed and converge back with the price downtrend.
The Relative Strength Index is a very useful and popular tool that you need to include in your technical analyses. It is not an infallible or magical prediction formula, but it will clearly put odds in your favor by confirming or refuting the relevancy of your trading position. Here is a good advice: tweak your own! When you are about to take a position, check the RSI on various timeframes by zooming in and out. Also, try various lengths. 14 Cycles is the most classic/popular choice but you can try higher values, like 21 or 28. Here is a picture that summarizes what we learned today.
In a future article, we will dive deeper and show you how to integrate the RSI in a full trading procedure, how to use it in conjunction with other indicators and even how to create an algorithm that will calculate it and send relevant signals to you. Stay tuned and don’t forget to use our referral link if you want to trade on Bitmex, you’ll save 10% off your fees, which is a lot!