What is relative strength index: timing crypto reversals with RSI

Timing the market is no easy feat. However, it can be made more manageable with technical analysis and momentum indicators like the relative strength index (RSI). As one of the more popular trading indicators in a crypto trader's technical analysis arsenal, RSI lets any trader immediately determine if a coin or token is overbought or oversold at a glance. Curious about the RSI indicator and mastering its ins and outs? From learning about what RSI is to understanding how RSI works, let's dive into the world of RSI and uncover how this momentum indicator can help you make more informed crypto trading decisions.

TL;DR

• RSI is a beginner-friendly technical indicator that shows if an asset is overbought or oversold.

• As a simple-to-understand line indicator, RSI excels in clearly portraying trading opportunities and providing insights into the recent momentum driving the asset's price.

• Despite being a handy momentum indicator, RSI tends to be less reliable in trending markets and fails to take into account trading volume.

• Advanced RSI tips include divergence analysis, relative strength comparison, and RSI channel identification.

• Success with crypto trading when using the RSI indicator involves a mix of good risk management, trend identification, and the use of complementary trading indicators.

What is the relative strength index (RSI) indicator?

Relative strength Index is a popular trading indicator in technical analysis that gauges an asset's momentum based on recent prices within a chosen timeframe. By analyzing the volatility and magnitude of recent price changes, RSI displays a score ranging from 0 to 100 that suggests whether the asset is overbought or oversold. Overall, RSI works best when an asset is trading in a range as it helps traders identify potential entry or exit points.

How does RSI work?

The RSI is displayed as a line on a scale of 0 to 100. Put simply, if the RSI is above 70, the asset is considered overbought, indicating a potential price correction. Conversely, if the RSI is below 30, the asset is considered oversold, meaning a possible rebound could be in play.

While these overbought and oversold statuses sound straightforward, the reality is that asset prices can often persist in their current state for prolonged periods before their eventual correction. As such, most crypto traders often say that relying solely on RSI readings can be risky. We'll explore this concept further in the article when evaluating a trading example using RSI.

How is RSI calculated?

Relative strength = average gains / average lossesRSI = 100 - [100/(1 + relative strength)]

While the exact formula for calculating RSI might seem intimidating, it can be simplified into the following points. The RSI indicator considers the average price increases compared to the average price decreases over a chosen timeframe. As such, the relative strength takes into account these averages and then calculates a score reflecting the asset's relative strength during that period.

A key point to remember is that we're not looking at the actual price movements themselves. Rather, as a momentum indicator, RSI factors in the momentum behind these movements.

Interpreting RSI: overbought and oversold statuses

Now that you know how to broadly interpret RSI values, let's explore what they might tell you:

• RSI above 70 (overbought): The overbought status suggests that the market might be getting a bit overheated, where traders may be buying on emotions and hype rather than fundamentals. While a price correction isn't guaranteed, it's a good idea to be cautious and consider locking in your gains or waiting for a pullback before entering new positions.

• RSI below 30 (oversold): The oversold status could hint of a possible opportunity to actively buy the dip. When the market is overly pessimistic, prices might be undervalued to a greater extent because of bearish momentum. However, as prices could plunge further before bouncing back, traders are encouraged to confirm signs of bullish momentum before building a long position.

Pros and cons of using RSI

Every trading indicator has its pros and cons, and RSI is no different. Here's a brief overview of RSI's various strengths and weaknesses.

Strengths of RSI

As one of the more popular momentum indicators, here's why RSI is such a hit among crypto traders:

• Simple and easy to use: The RSI indicator itself is easy to interpret on charts given its straightforward line chart going from 0 to 100. This makes it accessible to both new and experienced traders.

• Provides insights into recent momentum: Rather than just telling you whether an asset is overbought or oversold, RSI goes one step further to reflect the speed and magnitude of recent price changes, therefore offering clues about market momentum.

• Identifies divergences: Divergences occur when the price and RSI move in opposite directions. This can be a sign of weakening momentum and a potential upcoming trend change.

Weaknesses of RSI

While RSI is a valuable tool, it's important to understand its limitations:

• Less reliable in trending market conditions: RSI works best in range-bound markets. In markets with strong trends, RSI numbers tend to stay in the overbought or oversold zone for prolonged periods. This makes it harder to identify clear trading signals.

• No volume consideration: RSI focuses solely on price movements and doesn't account for trading volume. As such, a surge in volume can immediately strengthen RSI signals, causing numbers to be heavily weighted and unreliable.

• Overdependence: As RSI is beginner-friendly with its clear overbought and oversold signals, crypto traders tend to solely rely on it for trading decisions and be more prone to confirmation biases.

Advanced RSI tips

While identifying overbought and oversold zones is a common use of RSI, experienced crypto traders can develop more nuanced trading strategies based on these basic observations:

• RSI divergence analysis: Divergences between price and RSI can be a way for crypto traders to gauge shifts in momentum and trend reversals. When the price makes a new high but the RSI fails to follow suit, it can signal a bearish divergence due to weakening momentum. Conversely, when prices go to a new low with an RSI uptick, it might indicate bullish divergence, where there's underlying buying pressure.

• Relative strength comparison: Crypto traders can consider comparing the RSI of different cryptocurrencies to gauge their relative strength. For example, if a large-cap's RSI consistently stays above 50 in a choppy market, it might suggest general bullishness and potential upside in the near future.

• RSI channel identification: By plotting horizontal lines at key RSI levels, traders can create channels on the RSI chart. Price movements often respect these channels, offering insights into potential support and resistance zones.

By implementing these advanced RSI techniques, experienced crypto traders can gain deeper insights into market sentiment, identify potential turning points, and develop more sophisticated trading strategies based off the signals from such momentum-based indicators.

Incorporating RSI into your crypto trading strategy

Source: OKX.com

Now that you understand the basics of RSI, let's see how you can incorporate it into your crypto trading strategy with our BTC perpetuals trading example. For this example, we'll be looking at a successful BTC long trade in early June 2024 and configuring the RSI indicator to display the asset's momentum over 14 periods, since that's the default time period used by most crypto traders.

Identifying your potential entry

Based on the BTC chart above, we can observe a noticeable uptrend forming on the four-hour timeframe after a series of pullbacks in late May 2024. This aligns with what we're seeing on the RSI as it's constantly hovering around 45 to 50, which is usually considered neutral given that it's sitting between both overbought and oversold zones. Taking into account the current price action of BTC, crypto traders are inclined to believe that this would make a good long entry.

Confirming the trend

To confirm this bullish trend, we could then use complimentary indicators and charting patterns alongside RSI to be more sure of established uptrends or downtrends. In this case, we can see that there's strong support forming at the range between $67,000 and $67,500. Judging by how BTC is trading, we can confirm that there is indeed a bullish trend forming as BTC prices consolidate around $67,500.

Entering and planning your potential exit

Based on the available signals garnered from the RSI and support lines drawn, crypto traders with a bullish inclination may choose to make a long entry on BTC perps. Let's assume you get filled at $67,500. Upon successful entry, you'll now need to plan your exit so you can lock in those gains. In this instance, let's once again reference the RSI indicator to judge when BTC begins to look overbought.

On June 5, 2024, we begin to see RSI levels cross into the overbought zone as it breaches 70. If you're trading on a short timeframe, this could be your cue to close your long position at about $70,500 to $71,000. To lock in those BTC gains, you can set up a stop-loss order at $70,000. This allows you to safely secure your gains in the event of a sudden pullback while monitoring BTC prices for any additional bullish news that may cause Bitcoin to go even higher.

Final words and next steps

The relative strength index is a valuable technical indicator that can help you gauge market sentiment and identify potential trading opportunities. By understanding its basic principles, limitations, and how to use it alongside other indicators, you can add another layer of analysis to your crypto trading toolbox that'll bring you one step closer to becoming a veteran crypto trader.Interested in putting your crypto trading experience to the test by trading Bitcoin? Check out our BTC spot and BTC futures trading pairs. Additionally, you can supplement your trading knowledge by checking out our guides to MACD and exponential moving averages.