What is the Relative Strength Index?(RSI) How it Work?

The term relative strength index (RSI) often appears in the context of the crypto market. It’s a popular technical indicator used to grasp the market trends. It’s important to understand it to identify the right time to buy or sell your coins to make a profit. If you wanted to know more about RSI, read on!

The article covers the basics of RSI, its working, relevance, applications in crypto trading, and its limitations.

What is the Relative Strength Index?

The Relative Strength Index (RSI) is a popular technical indicator used across the financial market. The RSI measures the recent price and magnitude changes of a security or a crypto token in the case of the crypto market. The origin of this popular indicator dates back to 1978. The RSI introduced by J. Welles Wilder Jr. is categorized as a momentum indicator. 

The RSI is plotted on a line graph with values ranging from 0 to 100. The numerical values will indicate trend reversals, helping investors to make decisions.

How Does RSI Work?

The RSI measures the strength of gains against losses for a fixed period of time. It compares the strength of the assets or popular cryptocurrencies on days when prices increase to days on which price decreases. 

Typically, the time period considered is 14 days. A mathematical formula is used to calculate the value by comparing average gains during up periods and average losses during down periods. Today, the platforms have automated the calculations. The values are plotted on a graph. The attained value indicates whether the asset is overbought or oversold. 

The formula for calculating RSI is as follows, 

 Relative Streghth Index (RSI) = 100 – [100/ (1 + Average Gain / Average Loss  )]

 Where,  Average Gain = sum of gain per period/time frame

               Average Loss = sum of loss per period/time frame

An RSI value above 70 indicates that the asset is overbought. Indicating that, prices have gone up at a faster pace, and a possible pullback is in order. On the other hand, a value below 30 suggests oversold territory. The token prices might have fallen too fast, and a bounce back is expected. If the value remains around 50, it’s considered a neutral position.

Significance of RSI

The RSI can be used to identify the market trends and understand the right time to buy or sell securities or commodities. The following are the scenarios where RSI is useful to understand the market.

• To identify whether the asset is overbought or oversold: A higher value indicates an overbought scenario, signalling the investors to sell. In contrast, a lower value indicates the token is oversold, signalling traders to buy.
• To confirm market trends: The RSI values between 40 and 90 generally correspond to upward momentum. The values between 10 and 60 are seen during the downturn. The values around 50 indicate a neutral status. The 40 to 50 range acts as support, while 50 to 60 corresponds to resistance.
• Spotting the Divergence: The divergence occurs when the RSI moves in the opposite direction from the prices. If RSI is making higher lows while the price is hitting lower, it suggests a potential upward trend, hence a bullish divergence. On the other hand, a bearish divergence is indicated when the RSI hits lower highs, and prices show higher highs.
• Trendline breaks: Drawing trendlines on the RSI would help to identify bearish and bullish momentum.

Relevance of RSI in Crypto Trading: Use Cases

Most of the crypto trading platforms list RSI. Interpreting it would help the investors to decide whether to buy or sell a cryptocurrency. The following section explores the use cases of RSI specifically in the lucrative crypto trading.

• The RSI helps to identify the exit and entry points: The crypto traders can go through the 14-day RSI value to decide whether to exit. As discussed above, if the RSI of the cryptocurrency has reached above 70, it might be the right time to exit. Similarly, the traders can wait till the value slides below 30 to buy.
• Gives an idea about the support and resistance levels of a cryptocurrency: The support and resistance levels are crucial for crypto traders. The resistance is the level above which a cryptocurrency struggles to cross. For example, a value around $3 is considered the key resistance level for XRP. On the other hand, support is the price below which the token struggles to decline. 
• Identify bullish and bearish divergence: Combined with the price chart, RSI can be used to identify the bullish and bearish divergence in the crypto market.
• Aids in swing trading: The swing crypto trading leverages the short-term price changes. The RSI can be used as an indicator for buy or sell signals. A trader may buy when the RSI of the cryptocoin dips below 30 and sell when it crosses 70, and buys again when the RSI dips again.

Limitations of RSI

As discussed in the above section, RSI is a critical indicator in the financial markets with a multitude of applications. Despite its advantages, the index is not without limitations. Here are some of the key limitations of the RSI.

• There are instances where RSI can give wrong signals. In a trending market, RSI may remain in the oversold or overbought territory for long periods, giving a false signal to the trader.
• The occurrence of a bullish or bearish divergence does not guarantee an immediate reversal in trend.
• The RSI can sometimes lag behind the market trends. 

The effectiveness of RSI also depends on the type of market and assets considered. Experts recommend using it in combination with other key market indicators for a comprehensive understanding of market trends.

Wrapping Up

RSI is an important indicator used for technical analysis across the financial markets. Numerous crypto exchange platforms utilize the RSI to predict trends, and investors use it to identify the right time to buy and sell the tokens. 

Nevertheless, it’s important to note that it has drawbacks as well. Hence, it’s not advised to solely rely on it. Rather, combining RSI with other key indicators such as moving averages, MACD, and changes in trade volumes, etc., is recommended. Besides, an RSI for a shorter period is more sensitive. 

Frequently Asked Questions on RSI