How to Use Relative Strength Index (RSI) In Cryptocurrency Trading

How to Use Relative Strength Index (RSI) In Crypto Trading

Table of Contents

Technical Analysis (TA) is one of the most popular approaches to monitor markets in an effort to anticipate the next price move. I explained the main differences between TA and fundamental analysis (FA) in a previous article. In the following lines, I’d like to discuss one particular TA indicator that can help you find accurate signals much easier. The indicator is called the Relative Strength Index (RSI). While it has been widely used by forex and stock traders, the indicator is quite relevant for cryptocurrencies as well, the same as the rest of TA tools.

The RSI is a momentum oscillator – you’ll probably find it under the “oscillators” category on your chart. It measures the magnitude of the latest price changes to help you assess the overbought or oversold levels in the price of a cryptocurrency.

The RSI is shown on the chart as an oscillator (a line graph that fluctuates between two extremes) and may have a reading from 0 to 100. Here is how the RSI looks on the chart (below the price action):

Relative Strength Index (RSI) - Crypto Trading
Relative Strength Index (RSI) – Crypto Trading

The indicator has been created by mechanical engineer turned trader J. Welles Wilder Jr., who introduced it in his 1978 book titled “New Concepts in Technical Trading Systems.” He also discussed other TA indicators in that book, including the Parabolic SAR, the Average True Range (ATR), and the Average Directional Index (ADX).

Prior to becoming an expert technical analyst, Wilder started his career as a mechanical engineer and later became a real estate developer. In 1972, he started trading company shares, though he couldn’t generate visible profits. After several years, Wilder converted his trading research and experience into mathematical formulas and indicators, which became the basis for the book. Many traders all over the world have adopted his indicators since then.

Besides the magnitude of price changes, the RSI also measures the speed (velocity) of price movements. It can really be a very helpful tool, especially in combination with other indicators, such as trend ones.

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How Does the Relative Strength Index (RSI) Indicator Work?

The RSI measures the latest changes in the cryptocurrency price over 14 periods by default (for example, 14 days on the daily chart or 14 hours on the hourly chart). It uses a formula that divides the average gain the price has had over that period by the average loss it has experienced and then generates a figure from 0 to 100.

The RSI has a fairly simple formula, though it is difficult to explain without going much into detail. You can check Wilder’s book for additional information about the formula. Here it is:

RSI = 100 – [100 / (1 + (Average of Upward Price Change/Average of Downward Price Change))]

The RSI usually increases as the number and size of bullish closes goes up, and it declines as the number or size of losses increases.

As mentioned above, the RSI is a momentum TA indicator, suggesting that it measures the rate at which the price is changing. When momentum goes up amid a bullish price, it shows that the cryptocurrency is being actively bought. If momentum goes up amid a bearish price, it suggests that investors are dumping the cryptocurrency.

Besides acting as a momentum indicator, the RSI is also an oscillator that helps cryptocurrency traders assess the overbought and oversold levels. It evaluates the crypto quotation on a scale of 0 to 100, given the last 14 periods that come by default. Thus, an RSI figure below 30 would usually indicate that the cryptocurrency is oversold, i.e. it is bottoming out. If the RSI is fluctuating above 70, it suggests that the cryptocurrency price is likely close to its peak, i.e. it is in the overbought territory.

Even though the indicator is set to reflect the last 14 periods, traders can freely choose to change that parameter to increase sensitivity by setting fewer periods or decrease it by putting more periods. Thus, a 5-day RSI will react to the latest price movement more aggressively than the one that tracks 21 days. On a side note, short-term traders may choose the RSI to consider 20 and 80 to regard as overbought and oversold levels rather than 30 and 70. This would generally improve the quality of signals.

Overbought and Oversold Levels

We have used the overbought and oversold terms very often in this article, but you may still be confused about their meaning, so let’s get more in-depth with this. The two terms refer to the price of the cryptocurrency in relation to its fair value. They help traders understand the market conditions at a given time and anticipate future trends based on that. Thus, overbought and oversold levels provide decent buy and sell signals for major cryptocurrencies. These levels have been mostly associated with foreign exchange pairs, company shares, and commodities, but the crypto market has adopted them as well.

For instance, when Bitcoin is regarded as overbought, it means that there has been noticed consistent bullish price movement for the last few periods. This can push the cryptocurrency to a higher price than its fair value. Once the market gets to the point of maturity and faces resistance – it happens when traders realize it’s too expensive – the price can retreat or correct and decline for a while to find its fair value.

In contrast, traders say that an asset is oversold when it has been seen as trading below its current value for a while. This suggests that the short-term bearish move might reverse soon and a rally might be on the horizon.

The main cause behind the overbought and oversold market conditions is the overreactions to news, especially when the crypto community is so reliant on social media channels like Twitter. Any major story that gets investors’ attraction can make a cryptocurrency overvalued or undervalued.

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Technical analysis is the best way to identify overbought and oversold levels. Traders can use the price chart and indicators like the RSI to identify patterns that point to some of the two levels. Besides the RSI, other oscillators, like Stochastic, can also help you determine the market conditions. Actually, the RSi and Stochastic are considered to be the most effective technical indicator to identify overbought and oversold levels. They can be used separately or together with other indicators.

How to Use Relative Strength Index (RSI) to Look for Divergences

Besides the RSI levels of 30 and 70, which may help you spot the overbought and oversold market conditions, you can also use the RSI to seek another type of signal – the divergence. The indicator helps traders anticipate trend reversals or determine the support and resistance levels based on the divergences, whether bullish or bearish.

A bullish divergence reflects a market condition where the cryptocurrency price and the RSI scores move in opposite directions. Thus, the RSI score increases and generates higher lows while the cryptocurrency price declines, creating lower lows. Traders call it a bullish divergence because they anticipate that the demand for the asset is accumulating despite the downtrend, suggesting a trend reversal that would propel prices higher. Here is an example of bullish divergence in the chart below:

Relative Strength Index (RSI) Divergences - Crypto Trading
Relative Strength Index (RSI) Divergences – Crypto Trading

Conversely, bearish divergences happen when the price seems to be bullish. The RSI indicator in this case is losing momentum as its score drops, generating lower highs while the price is creating higher highs. In this situation, the trend reversal will end up with a correction or longer-term downtrend dominated by bears.

Be careful with the RSI divergences during strong market trends, e.g. when the price is rallying or crashes. This is because this type of signal is less relevant during such market conditions. A strong downtrend can generate many bullish divergences before the actual reversal happens. Because of that, RSI divergences may work better during less volatile markets.

Crossover of Centerline

Most traders are using the RSI to look for the overbought and oversold market conditions and also identify divergences. However, some traders can also use the indicator to find centerline crossovers. For example, when the RSI breaks above the centerline (50), it suggests a rising trend.

A bullish centerline crossover happens when the indicator crosses the 50 line from bottom to top, getting closer to the 70 line. This suggests the trend is gaining momentum and is becoming stronger. Thus, traders can open long positions during a signal like this.

Conversely, when the RSI moves from above the centerline to below, it indicates a falling price. The bearish centerline crossover happens when the indicator crosses below the 50 line, getting closer to the 30 line. This suggests the market is dominated by bears and is losing strength. Traders may choose to go short until the RSI approaches the oversold territory.

Relative Strength Index (RSI) vs Stochastic

As mentioned earlier, the RSI and Stochastic are two of the most popular oscillators used by cryptocurrency traders. Even though they may provide similar signals, the two have different approaches and underlying theories. Stochastic was developed on the assumption that closing prices must close near the same direction as the existing trend. Elsewhere, the RSI determines overbought and oversold levels by measuring the speed and velocity of price movements. More crypto analysts would pick the RSI over Stochastic, but both are doing a great job.

Like the RSI, Stochastic values are displayed in a range between 0 and 100. When the oscillator is above 80, it suggests that the cryptocurrency is overbought. Conversely, the cryptocurrency is considered oversold when Stochastic drops below 20. As a rule, Stochastic consists of two lines – one that reflects that actual value of the indicator for each period, and another one pointing to its three-day simple moving average. In this way, traders can look for crossovers to anticipate trend reversals.

The Stochastic oscillator can also create divergences with the trending price action, which is regarded as an effective reversal signal as in the case of the RSI.

While the RSI was created to track the speed of price movements, the Stochastic oscillator formula is more efficient when the market is trading sideways. Thus, the RSI is more helpful in trending markets, while the other indicator is more useful when the price is ranging.

Relative Strength Index (RSI) vs Stochastic - Crypto Trading
Relative Strength Index (RSI) vs Stochastic – Crypto Trading

Relative Strength Index (RSI) vs MACD

Besides acting as an oscillator, the RSI is also a momentum indicator. Thus, it is often compared with the moving average convergence divergence (MACD) – another popular trend-following momentum indicator. The MACD reflects the relationship between two moving averages of the cryptocurrency price. According to the MACD formula, the indicator subtracts the 26-period exponential moving average (EMA) from the 12-period EMA. The result is the calculation of the MACD line that represents a histogram. On top of that, a nine-day EMA of the MACD, known as the signal line, is then plotted on the histogram. The signal line usually generates buy and sell signals depending on the crossovers of the MACD. Some charts might display two lines instead of one, like in the example below:

Relative Strength Index (RSI) vs MACD - Crypto Trading
Relative Strength Index (RSI) vs MACD – Crypto Trading

While the MACD analyzes the relationship between two EMAs, the RSI tracks the price change in relation to the latest price highs and lows. The two indicators are often used in conjunction to offer a complete picture of the market.

Both the RSI and the MACD measure the momentum of a cryptocurrency. However, they look into different factors and thus sometimes may provide contradictory signals. For instance, the RSI may indicate a reading above 70 for a longer period, suggesting that the cryptocurrency is in overbought condition and might experience a price decline soon. Meanwhile, the MACD can suggest that buying momentum is still getting stronger for the same cryptocurrency.

The Final Note

To recap, when working with the Relative Strength Index, you should make sure to check the settings, the score it provides (especially if it’s below 30 or higher than 70), and the bullish/bearish divergences. Nevertheless, you should remember that there is no technical indicator that will give you signals with 100% accuracy, especially when you rely only on it.

Thus, it would be much better to combine the RSI with other indicators, including trend and momentum ones, to prevent false signals and avoid inappropriate entries and exits. You can combine the RSI with moving averages, for example. You can check this article to know more about how to use moving averages.

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