Relative Strength Index (RSI)
The Relative Strength Index, commonly referred to as RSI, is a tool or metric used in the evaluation of cryptocurrencies, much like other financial assets. It's designed to reveal the current and historical strength or weakness of a cryptocurrency based on closing prices of a recent trading period.
Basics of Relative Strength Index (RSI)
How Does RSI Work?
RSI measures the speed and change of price movements. Its comparative nature allows traders to understand whether a cryptocurrency is being overbought or oversold. Mathematically, RSI is computed using the formula:
RSI = 100 - [100 / (1 + (Average of Upward Price Change / Average of Downward Price Change))]
The outcome of this formula is a value between 0 and 100. Traditionally, a RSI value over 70 indicates that a cryptocurrency might be overbought (thus, possibly overvalued) and could be due for a trend reversal or corrective pullback in price. On the other hand, an RSI reading below 30 suggests that the cryptocurrency may be oversold (therefore, possibly undervalued) and could possibly be due for a trend change or corrective price bounce.
Limitations of Using RSI
While RSI is a powerful tool in the hands of informed traders, it's fair to mention that it also has its limitations:
- RSI does not consider the fundamental factors of a cryptocurrency. Hence, it's blind to factors like project developments, partnerships, regulatory news, etc, that can impact the cryptocurrency's price. Therefore, the RSI should always be used in conjunction with other analysis tools.
- During strong trends, RSI may remain in overbought or oversold zones for a prolonged period. Therefore, merely depending on RSI might result in missed trading opportunities or potential false signals.
Using RSI in Cryptocurrency Trading
RSI is quite popular among cryptocurrency traders for its relative simplicity and proven effectiveness. Traders often use the RSI as one component in a varied suite of tools and techniques to predict future price activities and to generate tradable signals. This helps them make better-informed trading decisions.
Bear in mind that thorough understanding and practice are necessary to use the RSI effectively. Quite like any other analysis tool, misinterpretation can lead to losses.