How to use the RSI in Crypto ?
The RSI indicator is one of the best known but do you know how to use it effectively ?
- What is the RSI in crypto ?
- How to read the RSI ?
- The RSI formula
- The limits of the RSI
- How to use RSI in crypto?
- Chart Analysis
- RSI divergences
- The RSI coupled with another indicator
- What can we conclude ?
What is the RSI in crypto ?
The RSI or "Relative Strength Index" is an indicator of the oscillator class.
Oscillators are indicators that will vary between a high and a low bound depending on market dynamics.
The RSI is surely one of the most popular indicators for chartist analysis and trading strategies.
However, it is often misused.
In this article you will discover this indicator and above all how to use it effectively.
How to read the RSI ?
The RSI formula
Just like other indicators, the RSI is based on a precise mathematical formula.
The RSI is the relationship between the average of the x previous rises and the x previous falls. The variable x here represents a parameter of the indicator that you can change. If you take a small x, you will consider the average of the rises and falls of few candles and therefore create a reactive indicator. Conversely, a high x will take into account many candles, and therefore produce a smoother result. The default x is 14.
Here is the formula :
The limits of the RSI
With this formula, the RSI will be between 2 limits, one at 0 and one at 100.
Within these 2 limits, you will find 3 distinct zones:
The zone between 30 and 70 which is called the median zone. This is an interval where the RSI is in a normal state.
The zone between 0 and 30 corresponds to the oversold zone. Oversold occurs when there has been a big drop and therefore an imbalance. We expect the RSI to return to the median zone. This means that we can expect an increase in price in the more or less short term.
The zone between 70 and 100 corresponds to the overbought zone. The overbought zone occurs when there has been a big increase and therefore an imbalance. We expect the RSI to return to the middle zone. Therefore, we can expect a decrease in price in the short term.
The different zones are also parameters but I advise you to keep 30 and 70.
Now that we understand how the RSI is calculated and how to read it, we can start using it!
How to use RSI in crypto?
When we look at Youtube, we have the impression that the main use of the RSI is to play the passage of zones. When the RSI arrives in oversold it is necessary to buy, and vice versa.
In the example above, on the left the RSI is in overbought territory and stays there for a long time! Selling at this point would have been a big mistake. The RSI, like all other indicators, lags the price. As a general rule using the zone crossing is not effective.
I will show you 3 uses that will help you in your trading !
When you look at the price of an asset you usually draw lines or shapes to understand the dynamics. This is called chart analysis. And you can do the same whether it is with the RSI or other indicators.
You can draw supports where the RSI bounces, resistances where it taps, and triangles.... for example in the example below, the RSI traces for several months a descending resistance (green line) where it has tapped several times. We could expect strong bullish pressure when the RSI managed to break this resistance. The resistance was broken to send the price and the RSI up to the overbought zone.
In general, the limits of the upper and lower bounds (30 and 70) are support/resistance zones.
Once again we find divergences on a multitude of underlyings. The principle of a divergence is to identify inverse dynamics between the price and the indicator. If the price rises but the indicator falls, we have a bearish divergence. A bearish divergence means that we can expect the price to stop its upward momentum and start a generalized decline. On high timeframes, divergences give very precise indications. Same principle for bullish divergences.
Unfortunately it's quite complicated to automate them via an algorithm. But I still advise you to pay attention to it !
A bearish divergence is clearly visible on this example. Sure the price went a little higher but it was a first indication that the bullish momentum was losing strength. The idea is not to close your positions entirely, but rather to force yourself to take profits when this happens. Conversely, on bullish divergences, this is an opportunity to enter the market as shown in the second example.
Divergences can also help you in choosing the strategies you want to implement. If you have developed bearish and bullish strategies, daily divergences are good indications.
The RSI coupled with another indicator
Earlier I mentioned that using the RSI alone is not a good idea. Nevertheless, taking advantage of these bounds to confirm trades is relevant. When developing trading strategies, you will choose a basket of indicators. You will need one or more of these indicators to set position entries or exits.
I decide to take the "Supertrend" indicator to enter a position at a specific time. The idea with the RSI is to confirm and define the ideal moment to enter or exit the market. We have made a strategy with this indicator if you want to see.
For example, if my Supertrend tells me to enter, I'll check my RSI to make sure it's not overbought and vice versa. This will allow you to avoid buying when there has already been a lot of buying. And so you expect a return to normal, or a correction. With this technique, you will not enter on a big green candle but rather on the following red candle. On the long term you will optimize your trading. In the short term, sometimes this technique will prevent you from getting in when the market is rising sharply. This will deprive you of a good performance.
For automated trading, using the RSI in this way allows you to perfect your strategies easily. I invite you to backtest your strategies via our tools on our github or by looking at our different strategies.
As a rule of thumb, you should consider trading on a long term basis where market jolts will be smoothed out.
What can we conclude ?
The RSI is a simple but effective indicator. It is very often misused in the resources you can find on the internet. Via the 3 techniques above, your chart analysis and strategy creation will be enhanced.
When you have a trading strategy, do not hesitate to add the RSI to study the difference in performance, drawdown, winrate....
Systematically add the RSI on your charts to detect divergences that can save you a part of your investment.
Start building a precise plan if a daily divergence happens, DCA, profit taking, portfolio management...