Crypto Academy Week 12 - Homework Post for [@kouba01]. Cryptocurrency Trading with RSI

Hello again @kouba01. Let me say that I really like this kind of class with technical content. I take advantage of them a lot as they have information that I can then use as tools in my trading. This is not the first time I talk about RSI, however today I will give an extended, different, and fresh perspective.

Let's start

_{Image edited by me in Powerpoint.}

1- RSI Indicator

RSI is a technical indicator designed to provide a visual aid to help forecast the asset's price movements. Initially, it helps to determine whether the asset price is in an uptrend or downtrend. Secondly, it indicates whether the asset price is balanced or whether the price is too high and is optimal for sale or too low and is optimal for the purchase.

The explanation of the calculation is a bit technical, but I will try to explain the idea behind the process in simple terms.

I'll actually start at the end since it all comes down to solving an equation: ^Source

_{Image oh the RSI Formula edited by in me Word, and taken from Wikipedia.}

Naturally, the platform performs this operation for us at a rate of several times per minute.

The key point is to determine the RS factor. This results from the relation of the average or (exponential moving average) of the closing prices in an uptrend period divided by the average of the closing prices in a downtrend period.

2- Can we trust the RSI on cryptocurrency trading and why?

Yes, of course. It is a tool that has been in use since 1978 and has helped thousands of traders around the world. If it had not, it would not still be in use today.

A wonderful aspect of this indicator is that it is very easy to interpret, so it is excellent for people who are just starting out in the world of trading. In fact, RSI was the first indicator I learned to use.

Its simplicity makes it reliable since it does not depend on many variables, only on the average of closing prices of previous periods. In fact, as a mechanical engineer I can say that the fewer moving parts a machine have, the more reliable it is and the less likely it is to fail.

However, for large and high-risk trades it is preferable not to trade only with the RSI, but to assist with another indicator and use both together.

3- How do you configure the RSI indicator on the chart and what does the length parameter mean? Why is it equal to 14 by default? Can we change it?

Each Exchange and each platform is different, however, the way to configure the RSI is similar.

In general, the RSI parameters can be configured from the start when it is being placed on the price chart. Technically all platforms will present the option to configure every parameter of the indicator, from Length to the color of the lines if desired.

The parameter called Length refers to a number of periods of time.

Remember the calculation of the RS factor in the formula? Which was the relationship between the averages of the closing prices over a period of time. When we set the length, we are loading that factor into our formula.

The length parameter varies in conjunction with the time we set in the candlestick chart. So each unit of the Length parameter will always equal one candlestick on the chart. If we set Length=17, this refers to a period of 17 minutes, 17 hours, 17 days, depending on the period the chart is set to.

The length parameter is set to 14 by default, as its creator (J. Welles Wilder) thought it appropriate.

Setting length to 14 gives the indicator a period that gives more importance to values close in time and therefore more in line with the current trend. This results in a more accurate trend forecast.

A value above 14 would present several prices far from the current trend, and a value below 14 would not give enough points of comparison to perform the average calculation. In both cases, RSI would not be accurate enough.

However, this parameter can be changed and configured at our convenience.

I will explain the procedure to set up and change the Length in the Poloniex Exchange. All images were edited by me and taken from my Poloniex account. ^Source

1- Click on the indicators button.

_{Image edited by me and taken from my Poloniex account.}

2- Type "RSI" on the field.

_{Image edited by me and taken from my Poloniex account.}

3- Select Relative strength index option.

_{Image edited by me and taken from my Poloniex account.}

4-Click on the "settings" icon. A window called "inputs" will pop up, where a default length value of 14 will appear.

To change it, click on the arrows inside the green box.

_{Image edited by me and taken from my Poloniex account.}

4- How do you interpret the overbought and oversold signals when trading cryptocurrencies?

The RSI indicator has a central area where the graph curve oscillates, this area is limited between 30 and 70. When it is overbought, the curve breaks the upper limit of 70 and moves above it. At that moment we can interpret that the price of the asset is increasing rapidly because the demand exceeds the supply, therefore purchases well above the average price will be observed.

On the other hand, when it is oversold, the curve breaks the lower limit of 30 and moves below. At that moment we can interpret that the price of the asset decreases rapidly because supply exceeds demand, therefore sales well below the average price will be observed.

_{SBD/USD chart, RSI indicating overbought and oversold areas. Image edited by me and taken from Tradingview. ^Source}

5- How do we filter RSI signals to distinguish and recognize true signals from false signals.?

Although the RSI is a good indicator, the truth is that it is not infallible, so it can give false signals. For this reason, we must be attentive to certain clues that will help us not to make mistakes.

The most common false signal is overbought or oversold before the optimal moment in the price of the asset. These false signals are called Bearish and bullish divergences.

The way to filter these false signals is through patience.

For example, if the RSI chart breaks the lower (30) value we should not enter into buying yet, but rather wait for the asset price to develop. Once the RSI chart returns to the zone above 30 we should observe its behavior because if it remains between the 50 and 30 lines, it means that the price is still in a downtrend, therefore the price can go down even more and return to the oversold zone.

If on the other hand the RSI chart rises and positions above the (50) line, it means that a trend change has occurred.

The opposite case for overbought also applies in the opposite direction. If the RSI chart breaks the upper (70) value we should not enter into selling yet, but rather wait for the development of the asset price. Once the RSI chart returns to the zone below 70 we should observe its behavior because if it remains between the70 and 50 lines, it means that the price is still in an uptrend, therefore the price can go even higher and return to the overbought zone.

However, you can opt for another strategy, as some people prefer to split the sale of their asset into two or three parts. Selling an amount for example (50%) in the first signal and the rest in the second signal.

Another way to distinguish a false signal is to pay attention to the volume at the point of overbought and oversold. Usually, the volume is high prior to a trend change.

See this example:

_{STEEM/USD Chart. Real and false signals. Image edited by me iand taken from Tradingview. ^Source}

6- Review the chart of any pair and present the various signals from the RSI.

For my example I will use the ETH/USD pair, 1H, taken from the Tradingview website on Thursday, May 6.

In the first step, it is evident to see that the chart is in an uptrend, as the RSI chart is above the 50 line for most of the time period.

Then we find overbought in Signal 1, which turns into a peak higher 1. After this peak, the price drops slightly but still continues in an uptrend.

The third is the overbought Signal 2, which becomes a peak higher 2, again the price drops slightly but still remains in an uptrend.

We could say that Signal 3 is a false signal since the RSI shows overbought but after going down it remains above the 50 line and goes up again. Then signal 4 is generated, and the price of the asset rises forming a higher point 4.

Finally, the price remains in an uptrend and forms two peaks (higher 5 and 6) but the RSI shows no signal, which could be interpreted that the ETH price is rising gradually and in a controlled way, so we could expect a higher overbought peak in the future.

_{ETH/USD chart. Image edited by me iand taken from Tradingview. ^Source}

CONCLUSION

RSI is a wonderful indicator to learn and show the variables in the behavior of asset prices. However, it is still only a support tool.

The decision-making remains solely in our hands and can never depend on a signal from the RSI since as explained, the indicator presents false signals under certain circumstances.

For this reason, it is important to know the behavior of the market, apply other indicators, and master the reading of the charts, since the combination of all these tools will allow us to make the right decisions.

Finally, we must always keep in mind one caveat. RSI works best when the market is trending (bullish or bearish). When the asset price is moving laterally, RSI will not be able to give accurate signals.