The Relative Strength Index (RSI) is a technical indicator that tends to express the strength or the weakness of the market.
The formula how it is calculated is not required for you to know.
You need to know its meaning and why we consider it useful.
It does resize your chart but it doesn’t cover candlesticks so you can still see them.
The point of using RSI is to check does it align with the price action.
You do not have to keep it open all the time.
Firstly, it shows the value from 0 to 100.
What does this value mean and where does it come from is the fact that nobody needs.
What the majority finds useful are two levels: 30 and 70.
When the RSI is below 30, they think it is oversold and that it can’t go deeper down.
That’s the reason why they consider that as a bullish sign.
If the price can’t go deeper and if it has two ways to go (either up or down) they find it as a great sign for upward momentum.
On the other side, when the RSI value is above 70, they consider it bearish and call it overbought zone.
When something is overbought, it means there are too many people that bought, and it is hard to get new ones and even harder to keep those who bough still interested so they won’t start selling.
They think the price is high and that it can’t go higher.
This is how they use RSI.
For us, this is not the way to do it.
The low can become lower, and the high can become higher. A
s you can see in an example above, Bitcoin spent more than a year in the overbought area while the price kept rising.
You would be on the wrong side of the market for the whole year.
To be honest, even the best traders would start to doubt their results after being on the wrong side for a year, right?
As the looking for oversold/overbought areas won’t help you too much, the question is what will help you?
The reason why we use RSI is quite simple.
Its biggest usage is that it gives us a clear sign of current market momentum.
If the momentum is weak, we will double check our buy signs.
You do not want to buy something that is running out of steam the same way you don’t want to sell something that is gaining momentum.
How to measure momentum?
Same as every other indicator, RSI is also derived from the price.
Because of that, if the price is going up, you expect that the value of an indicator starts going up, right?
In most cases, it happens.
Then we say that there is momentum and that it is good.
If the price makes higher high, we expect from an indicator to do the same thing, makes a higher high.
If the price drops below previous low and creates a lower low, we expect from an indicator to do the same.
As long as this happens, we do not have any hidden sign from RSI.
It just simply confirm price action.
But, what happens if there they diverge?
What if price makes a higher high but an indicator struggle and creates lower high?
What if the price reaches lower low, while indicator makes higher low?
Because of this phenomena, we have two important trading terms that we like to use: bullish and bearish divergence.
Let’s get straight to it.
As you can see, the price formed higher high and higher low and it was followed by higher high and higher low by RSI.
At that moment, the momentum was good, so we didn’t have any sign for potential bearish momentum from RSI.
Once price reached a new higher high, RSI wasn’t able to sustain momentum and it was confirmed by forming lower high.
At that moment, we got the sign that the market is losing strength.
If you bought somewhere down there, you could consider booking at least some part of the profit.
These signs shouldn’t be used as the only reason to turn bearish but they are enough reason to start thinking off trend reversal once other trading tools start forming bearish signs.
In this example, we got bearish divergence that forms when the price reaches higher high while an indicator shows the weakness in the momentum by creating a lower high.
After we covered bearish divergence, it is time to cover bullish divergence as well.
On an example above, we have a clear presentation of bullish divergence.
How it get formed?
After forming two times lower highs and lower lows, the price was followed by lower low and lower high on RSI as well.
Then, once price created third time lower low, RSI made higher low and sparked the first hope for a reversal.
Then, next time price made a lower low, RSI made new high low.
At that moment, we saw that the downtrend is running out of the steam.
If it was happening on support, it would be a great sign for you as a trader who is looking to buy or looking for closing short that was opened somewhere upward.
To conclude, RSI is an indicator that is used to gives us hidden information about the strength of the trend.
As traders, we do not want to trade against trend momentum and if it is weakening, we do not want to be in that trend anymore.
It is not used for identifying oversold/overbought areas as there is a myth in the trading community.
It can spend months in the oversold/overbought area and if you are trying to trade that, it would cost you a lot.
Never use it as a single confirmation for entry.
Although it gives nice signs, we never suggest using it alone for entry but only in confluence with other charting tools.
Milos is an independent trader, with a background in journalism and publishing. Nomadic by nature, he’s lived in four different countries this decade. He’s fascinated by Blockchain technologies’ potential to reshape all aspects of our lives. Milos got into Bitcoin while completing his degree and hasn’t looked back since, writing about anything crypto-related. He is the co-founder of the Cryptoaims and he has a strong passion to educate people about this revolutionary technology.