There are many more tools and indicators available to traders today than there were 20 years ago. Trading assets and securities comes easier to everyday people with technological advancements. As more traders and developers enter the digital currency revolution they bring in their skills and talents creating new indicators for us to analyze data. A lot of today’s innovative tools of measurement stem from values given by the Relative Strength Index.
The RSI is an algorithmic trading tool that measures a currency pair’s price action momentum change. The indicator will take price action data and convey the information through a simple line graph. The original script was developed by J. Welles Wilder Jr. in 1978 to display the relationship between current price action and buying/selling conditions. The RSI ranges from 0-100 with most traders using parameters of 30-70. When the RSI is trending between 0-30 the price of the asset is generally considered oversold or “cheap.” When the asset is trending over 70 the price of the asset is typically considered overbought or “expensive.”
This photo shows a candlestick chart using the RSI indicator. The candlesticks are the upper portion of the chart and the RSI is the lower portion of the chart displayed in purple. We have previously discussed candlesticks in this blog.
Note how the RSI typically bounces between overbought and oversold conditions? Here is the same photo displaying those conditions along the upper and lower bands.
When the RSI is trending along the top of the upper band (usually 70) it typically signals that the asset currently being traded is overbought and considered expensive. When an asset is considered expensive, usually buyers would wait for an opportunity to buy at a cheaper price. That would be an indication to take profits for traders with open long positions. If you have no open long position, you can prepare your entry for a short position. This gives power to the sellers as there is more selling volume at peak highs in RSI conditions due to profit taking and short contract engagements. In turn this typically drives prices down.
Similar to overbought conditions (but reversed), when the RSI is displaying oversold conditions on the RSI indicator trending at or below 30 would be a reasonable time to buy. If the asset is oversold it is considered cheap which prompts potential buyers to take their entries. When buying volume increases it causes the price of the asset to rise as spectators look to enter and active short contracts take profits.
The easiest way to trade using the RSI indicator is to buy in oversold conditions and sell in overbought conditions. This sounds like the opposite action one might want to take however these scenarios yield some of the most proficient entry opportunities. Let’s take a look at that same price action area with potential profit ranges.
Generally speaking, you should always use multiple time frame analysis and additional tools/indicators to confirm or deny your positions. For the purpose of this article’s narrative we will use highlighted timeframes and only the RSI indicator. In the photo above we have highlighted two potential trades based solely off the 1 hour timeframe and the RSI indicator.
It is important to take note of where price currently is in relation to the RSI indicator to determine if you will be taking a long position or a short position. To take a long position means one would buy low in an attempt to sell higher later for a profit. To take a short position one would sell high in an attempt to rebuy the position back later at a cheaper price and pocket the difference as profits. Additionally, one can short a futures contract or position without owning the asset in order to wager on the price moving downward by using stable coin as collateral.
Referring to the photo above, the first opportunity we have is a long position represented on both the RSI graph and candlestick graph by the blue measurements. Opportunity 1 yields +9.85% after a 19 hour position. Opportunity 2 yields +20.84% from the same oversold entry as Opportunity 1; staying in the position however until the oversold signal is displayed by the RSI indicator after 2 days and 1 hour completes Opportunity 2.
In the above photo we have highlighted an opportunity for a short position based solely off the RSI indicators. Again, a trader would want to use multiple indicators and multiple timeframes to confirm or deny an entry to a trade. This highlight is to show the opportunities presented by the RSI indicator.
Measuring down from the overbought conditions represented by Opportunity 1 yields -7% after 1 day and 3 hours from the RSI overbought conditions. The RSI then entered a range of near oversold conditions signaling the end of Opportunity 1. However if that same position would have remained open until the later RSI oversold conditions broke below the lower band the potential for profit taking was -9.45% after 4 days and 6 hours.
The purpose of these photographs are to illustrate the opportunity relationship between the RSI and price action. This is the basic concept of trading with the RSI indicator. Look for long opportunities in oversold conditions, and short opportunities in overbought conditions. Let us take a step further to analyze the best use case for the RSI indicator known as divergence.
Perhaps the most useful application of the RSI indicator is the ability to find divergence. Divergence in trading is when an indicator gives conflicting information from price action. There are generally two types of divergence: bullish and bearish. These can be broken down further to regular or hidden.
Regular bullish divergence is displayed through candlesticks forming a lower low while the RSI displays a higher low. In the photo below we observe regular bullish divergence.
In the above photo we can see by the blue underline that candlesticks have displayed a lower low in price action while the RSI is displaying a higher low. The angles of the lines are contradictory to each other and facing opposite directions. When a trader observes RSI divergence it is most opportune to enter on the open of the next candle to confirm that price will go up and that the low of the divergence has passed.
Entering from the divergence signal we can take Opportunity 1 to previous resistance levels for a cool +14.03%. Opportunity 2 uses the same entry however carries the position open longer until a higher profit of 18.81% is achieved. A divergence signal typically presents an excellent trading opportunity.
Another form of bullish divergence is known as hidden bullish divergence. This type of divergence is more difficult to spot but provides an equally exceptional opportunity to take a position. With regular bullish divergence the candlesticks form a lower low while the RSI shows a higher low. With hidden bullish divergence the candlesticks display a higher low while the RSI displays lower low. Below is a photo example of hidden bullish divergence.
In the above photo you can see the two trend lines are sloping against each other. The line underneath the candlesticks goes up while the line underneath the RSI goes down. The following opportunities yielded +5.88% and +7.97% from the same entry. This hidden divergence would have had a confident closer as we can observe regular bearish divergence in this same area. Being able to spot divergence would have provided a fine opportunity among this chart.
Regular bearish divergence is displayed by candlesticks forming a higher high while the RSI displays a lower high. This type of divergence will alert a trader to close any open long positions and prepare to open a short position. The photo below displays regular bearish divergence.
In the photo above you can see the previous hidden bullish divergence. The regular bearish divergence is displayed by the orange trend lines. Price action rises higher in the candlesticks while the RSI shows a lower high. The orange line on top of the candlesticks is facing a different slope than the line on top of the RSI indicator. This is indicative of a trend reversal and allows traders to create short opportunities. There were two plausible opportunities from this regular bearish divergence signal that would have yielded profitable short trades.
Hidden bearish divergence is when the candlesticks display a lower high while the RSI displays a higher high. This is not as easy to spot but will provide similar results to regular bearish divergence. Below is a photo example of hidden bearish divergence.
It is observed in the photo above there was a formidable trading opportunity presented by the hidden bearish divergence. Candlesticks connect two high points indicated by the orange line. On the RSI, connecting the two high points gives us an opposing slope thus proving us an opportunity to short. Even if one was not able to take the entire 14% profits there were still plenty of chances to short that set up.
Finding RSI divergence is not as plentiful as finding an overbought or oversold condition, however they will provide a trader with much better opportunities than just buying low and selling high. The RSI indicator is a great tool when used alone and can be combined with other tools and indicators. You can find a more detailed video on the RSI indicator and other available content in our trading course. At Crypto University, we present additional strategies to interpret different indicators in order to give our students the best edge over the markets.
By viewing any material or using the information within this publication you understand that this is general education material and you can not hold any person or entity responsible for loss or damages resulting from the content or general advice provided here. Trading cryptocurrency has potential rewards, but also potential risks. You must be aware of the risks and be willing to accept them in order to invest in the markets. Only trade with funds you can afford to lose. This publication is neither a solicitation nor an offer to buy/sell cryptocurrency or other financial assets. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed in any material on this website. The past performance of any trading system or methodology is not necessarily indicative of future results.
Written by Edward Gonzales © Crypto University 2021