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RSI Explained: A Guide for New Traders

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There are all kinds of technical indicators available for investors and traders alike when it comes to the markets. Unfortunately, things can start to get confusing with all of these choices on the charts You start with a basic candlestick chart, start applying some moving averages, and next thing you know, there’s a mess of trend lines, boxes, arrows, and writing all over your chart. One of the useful tools for investors is the relative strength index (RSI) and its ability to help note when an asset is oversold or overbought. Let’s break it down and go over what it is and why it’s useful.

Relative Strength Index (RSI)

First things first: what is it? First developed by technical analyst Welles Wilder, the RSI is a momentum indicator that compares recent gains and recent losses over a specified amount of time. The RSI is used to measure both the change of price movements and the speed at which they occur of an asset, in this case: cryptocurrencies. Okay great, but what does that actually mean?

 What that means is that investors are able to use the tool to tell when a specific asset is either overbought or oversold based on volume of trades and demand for an asset.

Overbought

When traders and investors say a certain asset is “overbought,” they mean that the current price of the asset is basically higher than it ought to be. Because of an increase in demand, as more individuals are buying the cryptocurrency, the price increases due to the limited amount of cryptocurrencies up for sale (think of a “price pump” - that’s what’s going on). Fluctuation in price is expected, but there are certain times when an asset is likely overvalued beyond the fundamentals and the price is likely to see a normalizing (dip back down to normal levels) soon. Investors use the RSI to help make calls about when an asset is overbought.

Oversold

As you might have guessed, the opposite of “overbought” is “oversold.” When traders talk about an “oversold” cryptocurrency, they’re referring to the exact opposite market condition of the overbought asset. In this case, the price of a cryptocurrency is significantly lower than what it ought to be. There can be a variety of reasons for a cryptocurrency to be oversold, but the main ones include “panic selling” and other forms of overreaction to Fear, Uncertainty, and Doubt (FUD). When an asset is oversold, much like when it is overbought, the expectation is that the frenzy will pass and the price will normalize after the short term drop and likely increase back to a more normal price point.

Okay Great, But How Do I Tell When It’s ‘Overbought’ or ‘Oversold?’

That’s a great question! This is where the RSI tool comes into play. In order to keep things simple, we’ll go over what to look for, but avoid the math behind calculating the RSI. If you’re interested in learning more about how to calculate the RSI by yourself, Investopedia has a nice outline of the math behind the indicator, which can be found here.

Basic RSI Usage

The standard for an RSI tends to use the values of 70 and 30 to determine what’s happening in the market. When the RSI is trending above 70, traders generally consider the asset to be overbought and overvalued compared to what the “normal” price of the asset should be. This is a good sell indicator as the consensus is that after this price surge, the asset is likely to dip in price again and normalize.

Real Trading Example with Bitcoin

 

[Charts of BTC/USD trading pair on Coinbase via Tradingview]

 

Conversely, when the RSI is trending below the 30 mark, traders generally consider the asset to be oversold and therefore, undervalued compared to what the “normal” price should be. In the case of an oversold asset with an RSI trending below 30, this is typically considered a buy signal as the cryptocurrency is likely to return to a more normal price point after the short term overselling is over.

Real Trading Example with Bitcoin

rsi

[Charts of BTC/USD trading pair on Coinbase via Tradingview]  

Conclusions

While the RSI is another fantastic tool traders have in their arsenal, it’s not to be used in a vacuum. Because there are so many different factors going on in the markets, the RSI is another way to see just one of those factors, not everything that should be taken into consideration. For example, think about what the likely RSI line would have looked like after the Bitconnect scandal. My guess is that it was probably quite “oversold,” but does that mean you should have purchased the “dip?” Obviously not. 

Remember to take other factors into consideration because there are plenty of other real world examples of situations just like Bitconnect and other false signals that are important for traders and investors to not overlook. Use the RSI as a tool among many tools, when developing your own buy and sell strategies. It’s useful, but not the end-all-be-all buy/sell indicator.

 

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