The best traders keep a sharp eye on an asset’s momentum. Here’s why the RSI and moving averages are the perfect indicators for Price analysis.
Technical analysis, the study of chart patterns, is a tool that helps traders increase their edge over others.
This is done by keeping the trader on the right side of the trend and providing warnings when the trend is about to reverse. There are many indicators and patterns that can accomplish this task but there is no one particular indicator that fits the bill for all market conditions.
Therefore, traders prefer to use a combination of indicators, which come in handy both during trending and range-bound markets. However, this does not mean the trader should clutter every chart with all the available indicators. In some cases, using too many indicators will only hamper the decision-making process and create confusion rather than assist the trader.
As traders develop their chart reading skills, they tend to reduce the number of indicators and use the ones that are more suited to their style of trading. Here again, there is no perfect set of indicators that will give better results than others, it is just a matter of preference and practice.
In this article, the set of indicators that will be discussed are moving averages and the relative strength index. Without going too deeply into the technicalities of each indicator, the basic ways of using them effectively will be highlighted. The methods discussed here are in no way complete, there are myriad other possibilities and traders can use the ones that work best for them. The explanation can be used as a guide for honing the analyzing skills further.
Moving averages are trend-following or also called lagging indicators as they provide delayed feedback after the price movement has already occurred. The most popular time frames that are used for trading and investing are the 20, 50, and 200-period moving averages. Short-term traders also use the 5 and 10-period moving averages but they tend to whipsaw and may not be suitable for everybody.
There are four types of moving averages: simple, exponential, smoothed and weighted but the most popular ones in use are the simple and exponential moving averages.
For calculation, exponential moving averages give more weightage to recent price analysis, hence they tend to respond quickly to price changes. On the other hand, a simple moving average gives equal weightage to the price data, hence they tend to be comparatively slow in responding to price changes.
Therefore, traders tend to use EMA for the shorter time frame, such as 10 and 20 as they catch the changes quickly and for the longer time frames, the simple moving averages are used because trends usually do not change direction quickly. For the current example, the 20-day EMA and the 50-day SMA will be used.
Relative Strength Index (RSI)
The relative strength index (RSI) is a momentum indicator, which captures changes in price and functions as an oscillator that ranges between values of 0 to 100.
As a general practice, readings of below 30 are termed as oversold, and above 70 are presumed to be overbought. While these boundaries work well during a range-bound market, they tend to give false signals during trending phases.
The most popular time frame used is a 14-period RSI. However, this is not set in stone because short-term traders may use a 5 or 7 period RSI while long-term investors may opt for 21- or even 30-period RSI.
One of the most popular uses for the RSI is spotting a divergence, which warns traders of a possible trend reversal. After the basics, let’s see some methods to use the indicators for analysis.
The first thing a trader should learn is to spot a trend. Trading in the direction of the trend is rewarding because an established trend offers several profitable trades. Let’s understand this with some crypto price action.
Examples of a range-bound market
In a range-bound market, the moving averages criss-cross each other and do not slope up or down for an extended period of time. See the area enclosed by the ellipse in the chart above where Bitcoin (BTC) remained range-bound and the moving averages flattened out. Such markets tend to lack direction and are difficult to forecast and trade.
As shown in the chart above, Polkadot’s (DOT) price was stuck in a range and the moving averages were flattish without any sense of direction. When the price is largely contained between two boundaries, the market is said to be range-bound.
Next, let’s try to spot a trending market because this is where the most lucrative trading opportunities arise.
Identifying an uptrend
Bitcoin was largely stuck in a range from Aug. 1, 2020, to Oct. 20, 2020. During this period, the moving averages were flat and without any direction.
However, on Oct. 21, 2020, the price broke above the range and the RSI also jumped into the overbought territory. During the start of a new trend, the RSI generally remains overbought for the initial period of the trend and the same could be seen here as well.
As the price analysis showed us, the 20-day EMA started to turn up first and then the 50-day SMA followed suit. When a trend starts, it generally remains in force for an extended period. Let’s look at another example of a trend.
After staying in a range from Sep. 6, 2020, to Dec. 27, 2020, DOT broke out of the range on Dec. 28, 2020. The RSI also rose to overbought levels above 70 and the moving averages started sloping up. Again, notice how the 20-day EMA was quick to move up while the 50-day SMA took time to catch up.
In the above case, the RSI did not remain overbought for an extended period but remained above 50, indicating one rule does not fit everywhere.
Identifying a downtrend
Unlike uptrends, which take time to form and remain in force for an extended period, downtrends are violent and can either stretch for a long time, similar to the 2018 crypto bear market, or could quickly reverse direction after a sharp fall.
The above chart has two important things for the trader to note. First, the RSI had been making lower tops since the end of February, even though the price had continued to move up. This is a classic sign of a possible trend reversal. Again, this is not foolproof but if traders combine the signal with the price action, then the possibility of avoiding a catastrophe is high.
The negative divergence on the RSI gained importance when the moving averages completed a bearish crossover where the 20-day EMA, which had been staying above the 50-day SMA for the past few months, broke below the 50-day SMA. This was a sign that the short-term price action was weakening and the trend may reverse.
After staying in a range for a few days, Bitcoin broke down on May 12 and the moving averages started to turn down. This, along with the RSI in the negative territory was a signal to traders that the trend was reversing. As long as the price remains below the moving averages and both the 20-day EMA and the 50-day SMA keep sloping down, the trend will remain bearish.
In the above chart we can see that after the uptrend, DOT became stuck in a range with the moving averages flattening out and criss-crossing each other. It is difficult to call this a top because the price could have gone either way. However, if the trader also looked at the RSI, it was flashing a negative divergence, warning of a possible reversal.
The sharp fall on May 19 confirmed the downtrend as both moving averages started to turn down and the RSI is in the negative zone.
Remember, no signal is absolute!
For most new traders, the moving averages and the RSI are essentially the starting point for identifying trends.
Investors dipping their toes in trading should definitely practice identifying the main trend as this could keep them from going against the market and getting burnt. In subsequent articles, entry and exit strategies using the indicators will be discussed.