RSI and Stochastic RSI indicators are important tools in the toolkit of every crypto trader because they give you information about the price movements, retracement, and trend continuation. Learn how to use them from this short guide.
What is RSI and how does it work?
RSI indicator was developed in 1978 by an American mechanical engineer, Korean War veteran and a real-estate developer J. Welles Wilder, famous for developing not only RSI, but also a few other technical analysis indicators, including Parabolic SAR and Average True Range.
RSI, or Relative Strength Index, is a technical indicator used to evaluate overvalued or undervalued conditions in the price of an asset. In other words, it helps you understand if the coin trades at a higher price than its real – “fair”- price, or, vice versa, at a lower market value than its intrinsic value. If the RSI indicator signals that the coin is overvalued or overbought, you may want to sell it, if the indicator says the coin is undervalued or oversold, it may be a good time to consider a buy deal.
The RSI indicator is an indicator that “oscillates” or fluctuates between two extreme values, 0 and 100, and every value within the bounds might potentially show in what phase the market is now: bearish or bullish. For example, in an uptrend, or bull market, RSI normally doesn’t fall below 40, with the 40-50 range acting as support. Of course, every indicator can be customized by an individual trader, and we will see the example of it below, but oftentimes 70 and 30 are the common levels to pay attention to. The level above 70 usually indicates that the market is overbought, and below 30 means that it is oversold.
How to set up an RSI indicator?
In his book New Concepts in Technical Trading Systems, while talking about RSI, the indicator developer J. Welles Wilder uses trading strategy examples with 14-period time frames. He gives a few reasons for such a choice, one of which seems very metaphysical and the other one has proven to be quite practical.
According to Wilder, the 14-day time frame has a certain basis in nature relating to the time it takes the moon to travel around our planet. Also, Wilder has found the 14-period time frame especially effective on a daily time frame, since he was into swing trading. But depending on your settings and trading style, you might want to set up your own values.
The most recommended time frame for this particular indicator is 14 days, but depending on your settings and trading style, you can adjust.
How to read the RSI indicator?
Take a look at the chart down below and compare a 5-day RSI vs 14-day RSI vs 50-day RSI.
Three different RSI setups demonstrate that the 5-day RSI is very frequently giving trading signals, the 14-period RSI gives several signals, and the 50-day RSI gives just two very good trading signals throughout the time period selected.
That means that using a shorter time frame, for example 5 days, will cause the RSI indicator to reach extreme values (above 70 or below 30) more often. Thus, this setup seems like the best RSI period for scalping. The 14-day period is good for swing trading or day trading and a 50-day period is a good fit for longer investments.
How to calculate RSI?
These days you don’t need to calculate RSI manually if you use a fully-automated solution like TradeSanta.
But what exactly happens under the hood? The formula presented down below is simply a way for you to understand how TradeSanta calculates the entry point, but you will never have to apply this formula manually.
- The time period we use is 14 days
- SMA returns an average gain and an average loss over the past 14 days
- Calculate Relative Strength (RS) by dividing the average gain on the up days by the average loss on the down days
- Now obtain RSI by subtracting 100/(1 + RS) from 100. RSI = 100 – 100 /(1 + RS )
When using RSI, don’t worry if your bot takes some time to enter the market. It waits for the signal from the technical indicator. Depending on your pair it may take from several minutes to several hours.
RSI divergence and convergence
Together with the price of the coin, RSI might draw two pattern types on the chart known as RSI convergence or RSI divergence. RSI convergence confirms the trend. RSI divergence shows the change in the trend.
Take a look at the definitions and the charts down below to get a deeper understanding of what is meant by all that.
- RSI convergence occurs when the RSI direction mirrors the price trend.
- RSI divergence occurs when the price moves in the opposite direction of the RSI.
If you take a closer look at the blue line of the price on the chart up above, you will see that the price falls right after a 3-hour bull run, which the hidden RSI divergence pattern has predicted earlier.
Here’s an RSI divergence cheat sheet you can save to your bookmarks in order to recognize change in trend.
Stoch RSI and how does it work?
Basically, Stochastic RSI is an indicator of the RSI indicator. RSI is a derivative of price. StochRSI is a derivative of RSI itself.
Developed in 1994 by a technical analyst Tushar S. Chande and a futures trader Stanley Kroll, the StochRSI indicator was originally described in their book “The New Technical Trader”. The famous RSI indicator and other technical indicators sending overbought or oversold signals had already existed, but the StochRSI indicator was an improvement on a sensitivity and a number of signals the oscillator could show.
Chande and Kroll suggest setting overbought/oversold signals at 80/20 for StochRSI rather than the 70/30 normally used for RSI.
StochRSI, or stochastic RSI, concentrates on market momentum. Use Stochastic RSI to read overbought or oversold market conditions. A reading above 80 is considered overbought, while a reading below 20 is considered oversold. Remember, depending on your settings, the chart will or will not send you a timely signal to enter the market, so these settings are kind of important.
StockRSI displays two lines: the %K line and the %D line, sometimes displayed as a dotted line. A 14-period %K would be derived out of the most recent close, the highest high over the last 14 periods and the lowest low over the last 14 periods – see the formula below. %D is a 3-day simple moving average of %K.
Along with identifying overbought and oversold conditions, StochRSI can be used to identify short-term trends by looking at it in the context of an oscillator with a centerline at 50. When the StochRSI is above 50, the asset may be seen as trending higher than its intrinsic value and, vice versa, when it’s below 50.
Stochastic RSI Formula
As TradingView defines it, the Stoch RSI is essentially an indicator of an indicator. Stochastic RSI is a stochastic oscillator that is applied to a set of RSI values rather than to standard price data. That’s why the formula used for the calculation of a value looks like this:
Stoch RSI = (RSI – Lowest Low RSI) / (Highest High RSI – Lowest Low RSI)
Can I use stochastic RSI and RSI together?
So, which is better RSI or stochastic RSI? Ideally, when making a trading decision, you should try and find as many indicators as possible to strengthen your opinion. Stochastic RSI and RSI work well together, measuring the RSI momentum.
While choosing between RSI and StochRSI or maybe using both of them in conjunction, remember that these two indicators are good to spot oversold and overbought signals. However, the main difference between RSI and Stochastic RSI lies in under what conditions these indicators operate the best.
Defining stochastic indicators, a famous securities trader, author, educator, speaker and technical analyst George Lane said that “stochastics measure the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price.” That said, the very sensitive Stochastic RSI works the best in the flat markets, and foresees the change of trend before the rocket goes up in the air. Use Stochastic RSI under these circumstances.
RSI, however, is good to go with in trending markets since it was developed to gauge momentum and identify overbought and oversold conditions.
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