The RSI is a technical indicator used to quantify the gains and losses of an asset over time.
While it was initially designed for stocks, it can be applied to any tradable goods such as forex, cryptocurrencies or derivatives.
The RSI is expressed as a number between 0 and 100, with anything above 70 considered to be “overbought” and anything below 30 thought of as “oversold”.
The Relative Strength Index (RSI) can be seen as a momentum oscillator: i.e., when the RSI moves up quickly, this indicates that an asset’s price increases, making it a good time to buy.
Similarly, when the RSI moves down rapidly, this implies that an asset’s price is dropping — it might be a good time to sell to capitalize on a loss.
- Welles Wilder developed the RSI in 1978.
The fundamental idea behind using the Relative Strength Index (RSI) indicator is measuring ‘momentum’ over some time.
In technical analysis, many momentum indicators have been developed based on similar principles.
One such example would be Moving Average Convergence/Divergence (MACD), a popular indicator that has a similar purpose to the RSI. It is important to know that MACD measures momentum in terms of ‘price’ while the RSI measures it in terms of ‘distance from its moving average’.
In other words, if an asset’s price goes above its moving average, the RSI will rise and vice versa.
Moving Average
To fully understand how the Relative Strength Index (RSI) works, you must understand a “moving average”.
A moving average aggregates data over some time by calculating simple arithmetic mean.
The idea behind using a moving average is that it helps smooth out volatility in a series of numbers so that trends can be more easily observed.
For example, let’s say you have three numbers: 1, 2 and 4. If you calculate their arithmetic mean (adding them up and dividing by 3), you’ll get the number 2. This is the average of the three numbers.
We quote percentages in our examples (e.g., 30 and 70) because it will be much easier to relate to once we start applying real-world examples to understand how RSI works.
Now that we’ve learnt what a moving average is let’s see how we can apply this concept with regards to the Relative Strength Index (RSI). Just as before, you’ll need three components: a simple moving average, an exponential moving average and an asset’s closing price over some time.
Applying RSI
The RSI calculates its value by measuring the difference between an asset’s closing price and a simple moving average over some time. We’ll refer to this as ‘n’.
The default setting for “n” is 14, but you can adjust it depending on what suits your trading style best.
When this number goes up, it means that the asset’s closing price has risen above its moving average, which makes it a bullish signal. This will cause the Relative Strength Index (RSI) to go up too.
Likewise, when this number goes down, it means that the asset’s closing price has fallen below its bearish moving average. Thus, whenever this happens, the RSI will go down.
Continuing with our example, let’s say that you have some assets which are “oversold” by having an RSI value below 30.
This means that they’re currently trading close to their moving average, and it might be a good time to buy cryptocurrencies to benefit from the bullish momentum.
However, if the RSI also shows downward momentum (i.e., it is decreasing), then this might not necessarily be a good idea because cryptocurrencies are dropping in price too quickly. Thus, waiting for the asset’s price to get closer towards its moving average may be preferable instead of buying early.
On the other hand, let’s say that you had an asset rising rapidly, which has an RSI value above 70. This is an indication that the asset’s price is rising faster than their moving average, and it might be a good time to sell assets to take advantage of this higher-than-average momentum.
However, if you had another asset that was “overbought” with an RSI value below 30, then the chances are cryptocurrency prices are dropping too quickly; thus, it would be better to hold off on selling until the trend reverses for both assets.
The Relative Strength Index (RSI) can give us very useful information about how close an asset’s price is to its moving average at any given time. The fact that it takes into account up and down ‘momentum’ within an asset makes it extremely relevant.
