RSI gets mentioned all the time. On Twitter by the so-called 'gurus' as well as on CNBC by Cramer and other hosts.
The reason why is because RSI is a really legitimate indicator. But there are two HUGE misconceptions about how the RSI actually works (Relative Strength Index) that lead people to sell at inane times or enter into positions illogically
Misconception #1: When the RSI is Going Down, So is the Price
This is not true in the slightest bit actually (I'll demonstrate this in the next post).
The RSI stands for Relative STRENGTH Index, not Relative Price Index. Also, it draws readings based solely on prior price data on a fixed time frame (i.e., 14 periods is the typical 'stock' time frame for the RSI).
So, even though the RSI is a momentum indicator (i.e., not lagging like a moving average), it still has a lot of functionality that derives from lagging indicators.
What Does This Mean?
That means that the RSI only looks at the strength of the asset's price trend relative to what it was before.
Here is the formula for the RSI courtesy of investopedia.
Don't trip about making sense of the calculation if math isn't your thing, I'm going to tell you what this is actually calculating in plain English in the next message and everything will make a LOT more sense to you.
How the RSI Calculates
The RSI starts by looking at a given time frame. Let's say 14 periods. A "period" is a candle, by the way. So if you have your chart on the 4-hour resolution, then every period is a 4-hour block. So if we have our chart on the daily resolution, then 14 periods would be 14 days.
Back to RSI - the RSI looks at each one of those periods individually and evaluates whether there was a gain/loss.
So let's say... Tuesday of this week. Did Bitcoin gain or lose? Ok, how much did it gain or lose by? 5%? Cool. And it makes a mental note of that (humanizing the RSI to simplify this).
After it does that for the last 14 periods, it looks at all the days Bitcoin gained and calculates the average percentage gain among those days.
Then it looks at all the periods where Bitcoin lost and takes the average percentage loss among all of the losses.
That's the first part.
Smoothing Out the Values: RSI Part Two
Once we have that average % of gain or loss for the last 14 periods (using the method we described above), we then take that number and multiple it by 13 (same thing as adding it 13 times).
We do that for the gains & the losses separately. We do it 13 times because we're going to replace the 14th value from the calculation above with the current candle (for whatever period we're on).
So its (average gain * 13) + (current gain average).
The 'current gain average' may be confusing, but basically you:
- Offset '1' candle. That means look at the candle before the one that you're one and then trackback 14 periods.
- Take that average gain over that period.
- Multiply it by 13.
- Then look at the candle that you're on now (at that present moment)
- Calculate the average gain for the past 14 candles (including that one)
- Add that value to the average gain of the past 14 candles (starting one back) that you multiplied by 13.
- Do the same for the losses
Voila, now you have the RSI(14) in front of you (which means that you always need one more period than the period that you're looking at in order to calculate it if you're using the J Welles methodology ; he's the inventor of RSI.
What This All Means in the Grand Scheme For RSI Calculations
What this all amounts to in plain English is that when an RSI is increasing, its telling you that not only is the price increasing, but its increasing at an increasing rate.
So to make sense of that, imagine Bitcoin gains by:
- Monday = +3%
- Tuesday = +4%
- Wednesday +5%
- Thursday = +6%
That is essentially what the RSI is telling us is happening (except over 14 periods, averaged out).
By factoring in the average # of gains / losses, its able to factor out an outlier period (let's say there was a candle spike of +80% for some crazy ass reason; or this was Gamestop, perhaps) - if every other period (14), was a loss, then the RSI would still be on a downward move.
Also, this sets up a situation where the price can still be increasing and the RSI can decrease.
For example if we saw Bitcoin do this:
- Monday = +6%
- Tuesday = +5%
- Wednesday +4%
- Thursday = +3%
The RSI would be decreasing (again, that's a simplified view to give you the gist) even though the price is still increasing (just at a slowed rate).
Thus, when we see the RSI diverge from the price (i.e., price trade sideways and the RSI is going up), that divergence can sometimes be a critical indicator that tells us that there may be some slow accumulation occurring underneath the surface.
Important to Know When Accumulation is Taking Place
There are a lot of traders that will look at a project that's dropped -90%+ in this space and say, "Oh, I'm going to get in now because it will get a lot of momentum and pop back up to where it was prior!"
This almost never happens though. And you can tell that it won't because if you look at the momentum indicators like the RSI, there will be no underlying trends to indicate that this is going to happen.