Buying crypto when the price is at a peak and selling it when it is low is the worst nightmare for crypto traders. This situation happens because of reversing price trends. In essence, investors do not want to buy crypto in the present if they know the price will drop shortly, nor sell crypto today if they know the price will continue to skyrocket. Technical analysis tool called relative strength indicator or RSI helps them predict trend reversals. Let us understand the basics of this tool in this article.
In the crypto market, the term RSI refers to the cryptocurrency momentum. It includes both the speed and magnitude of price changes. Investors often use this indicator to determine if crypto is overbought or oversold. This data could help determine probable trading entry and exit signals.
What is overbought and oversold?
Price movement does not stick to a trend forever, especially in the highly volatile crypto market. If it happens, traders get alerted because they know it is not normal; they know it will eventually change direction. Afterward, they decide whether to buy or sell the cryptos that they are holding.
According to Yahoo Finance, overbought “describes a period of time where there has been a significant and consistent upward move in price over a period of time without much pullback.” For traders, this is an indication that the price will not continue to increase but will instead fall, prompting them to sell their crypto assets. If they get late, it will be a loss for them. Also, at this point, traders halt buying cryptos because they know that price will soon decline. As a seller, to capitaliSe during low-price periods is the goal. It is not practical to purchase cryptocurrency in this case because there is no clear indicator that the price will climb in the foreseeable future.
Yahoo Finance added that oversold, on the other hand, “describes a period of time where there has been a significant and consistent downward move in price over a period of time without much pullback.” It is a sign that the crypto price will not continue to fall for traders and will rise instead. They will take the opportunity to buy crypto at this point since the price is low. They know it will become profitable since oversold indicates a price hike in the relevant period, a time favorable for sellers as they can sell their cryptos at a high cost. Traders tend to hold off on selling cryptos since it is not profitable given the low selling price; also, they do not want to lose their crypto assets now and miss out on the chance to sell them at a higher price later.
How to calculate RSI?
Overbought and oversold periods, however, can stay for a long time. To predict when it will happen, traders use RSI. Crypto trading platforms already calculate it to make it easier for traders. But to better grasp its concept, let us study how to compute RSI.
First, choose a previous period. Generally, traders set it at 14 days, but it can be shorter or longer. Then, add up the average gains and divide by the average losses of that period you have chosen. The calculation that you will get refers to as relative strength. The relative strength value then is graphed on a scale of zero to one hundred.
Plotting a line allows investors to gauge momentum in relative terms, which means comparing the present value of the indicator to previous values. This comparison may make it easier to predict when a current cryptocurrency trend may reverse. But why compare the past to the present? It all comes back to one of the technical analysis’ basic tenets: market patterns from the past are relevant to the present.
To identify potential trend changes, overbought and oversold comes into the picture. Cointelegraph explains that some investors define oversold level as an RSI value below 30. According to some tech traders, the RSI crossing back above 30 indicates a potential bullish entry signal. It means it is the best time to buy crypto as the trend tends to rise. The same idea goes with the exit signals, but this time investors use overbought values. An RSI number greater than 70 is considered overbought by technical traders. When the RSI hits back to 70, specialists consider it a potential exit signal. Meaning, traders tend to sell their crypto before the price falls.
Although RSI appears to be a highly technical term, it does not imply that its application is without risk. One of the most significant disadvantages of using RSI is that its signals are not always reliable. RSI does not consider events that influence the price of a cryptocurrency, such as economic news, earnings, and fundamental elements. Other sources of confirmation, like volume and the overall trend of the crypto market, are commonly combined with the RSI. For this reason, most successful traders utilize reliable trading software on the internet, such as Bitcoin System.