Overbought and Oversold Index (RSI)

Traders use various technical indicators to analyze quotes to help them understand when buying or selling an asset is better. One of the most popular indicators among crypto traders is RSI.

What is RSI?

Relative Strength Index (RSI) is a relative strength index or, as it is also called, an overbought and oversold index. This technical indicator is a momentum oscillator used to determine the speed and magnitude of price changes.

The overbought and oversold index was developed back in 1978 by Welles Wilder and quickly gained popularity among traders in the stock and currency markets. Still, crypto traders have also often started to use it in their trades.

Why and how is RSI used?

As the name suggests, the Relative Strength Index determines an asset's overbought or oversold level. Still, it is also often used in various tasks, such as deciding trend direction or identifying bullish/bearish divergence.

RSI and many other technical indicators have a scale from 0 to 100, where 0 is oversold, and 100 is the maximum overbought. Indices rarely reach absolute values, but the closer the current indicator is to them, the stronger its weight.

Conventionally, traders divide the RSI scale into three zones:

Oversold zone (0-30). If the value of the index is within these indicators, the asset is considered oversold, which may signal an imminent change in price direction. Traders take it as a signal to buy or open a long position (long). The lower the index value, the higher the probability of price reversal.
Neutral zone (31-69). Most often, when the index value is in this area, the price moves in a narrow corridor without significant deviations to one side or another. In this case, traders usually follow the price to determine the trend direction or possible divergence.
Overbought zone (70-100). If the price is in this zone, it is considered too overvalued. Traders take this value as a signal to sell or open a short position (short).

This division is very conditional because the values may vary depending on the individual trader's style or strategy. For example, many traders often use levels 20 and 80 for analysis, not 30 and 70. It is also not uncommon to find levels 40 and 60. The choice of levels also depends on other settings: timeframes and RSI period.

It is important to emphasize that indices have a symbolic value and do not work 100%. The market is influenced by many other factors, such as news background, incidents, and sudden price movements caused by large sales or purchases.

Here are some examples of overbought and oversold index applications:

Price reversal. If an asset price correction in an uptrend shows a local low higher than the previous correction, but the RSI shows a lower low, this may indicate a negative price reversal. A reversal in a downtrend is calculated similarly, only "inverted".
Trend direction. Andrew Cardwell, a follower of Wilder, found that in an uptrend, the values of the Relative Strength Index most often fluctuate between 40-80, and in a downtrend, between 60-20. In this case, the RSI index's direction coincides with the price movement vector.
Divergence. In the case when the rate of an asset is growing with a falling index value, on the contrary, it may mean an approaching price reversal. It occurs when the investment reaches the maximum local price and the indicator value surpasses the minimum.

How to adjust RSI?

Almost all advanced services that provide charts and other analytical tools support the overbought and oversold index. Traders usually use built-in charts on exchanges or specialized third-party services like Trading View, which are also often integrated into the interface of cryptocurrency exchanges. It is enough to simply add the index to the chart and then adjust the RSI to your preferences.

The Relative Strength Index has three primary parameters:

Indicator length;
Type of moving average (MA) to determine the RSI value;
Timeframe.

The RSI length is the period based on which the current index value is calculated, depending on the selected timeframe. Most often, the default length is set to 14. This means that, for example, with an hour timeframe, the current value is calculated based on the index data for the last 14 hours. The longer the RSI length, the smoother the value will be.

A length with a value of 14 is suitable for day trading and swing trading, where traders make short-term trades during the day. More aggressive traders, such as longs and shorts with minute trades, use shorter periods of 11 or less, while investors and long-term traders usually increase the period to 20 or even 30.

The trader also chooses the type of moving average used in calculating the RSI chart. The defaults are often the moving average (SMA) and exponential moving average (EMA). Using a moving average will help eliminate unnecessary noise in the analysis and more accurately determine trade entry points.

Finally, using the timeframe can reduce noise and make the RSI chart more fluctuating. The RSI line will be smoother if you choose a more extended timeframe than the one set on the asset chart and vice versa.