For more on bitcoin investing, see: The Essential Guide on How to Buy Bitcoins.
Bitcoin prices have been on a tear, and the introduction of futures contracts will likely make this new asset class more main stream. Prices have surged in 2017, climbing from $1,000 per bitcoin to more than $19,000 on Coinbase for a bitcoin. Similar to other asset class, as liquidity drives volume, technical indicators will be able to help traders determine if prices are rich or cheap. One of the most efficient indicator is the relative strength index (RSI) which is a momentum oscillator that allows investors to determine if prices are accelerating or decelerating and whether prices are overbought or oversold.
The RSI Indicator was developed by J. Welles Wilder as a momentum oscillator that measures the rate of change of a price of an asset within a specific period. The index generates a number from 1-100 by looking at the average gain and dividing that by the average loss over a certain period. The default period that is used to calculate the RSI is 14-days. There are several ways that trader’s can use the RSI to help determine future changes to bitcoin prices.
How to Use the RSI
1. The most common way the RSI is used is to evaluate whether prices are overbought or oversold.
An overbought condition is one where the rapid increase in prices action has become unsustainable, and will likely retrace. An oversold condition is the opposite where prices declines are overextended and are likely to lead to a rebound.
While overbought and oversold readings can be short-lived, momentum can accelerate for extended periods, which brings caution into the equation. Generally, when the RSI moves above the 70 level, the underlying asset is considered overbought. When the RSI declines below the 30 level, prices are considered oversold. The purple shaded area around the RSI shows the neutral range where the RSI is below 70 and above 30. A basic RSI trading strategy would be one where you would sell bitcoin when the RSI moves above 70, and purchase bitcoin when the RSI moved below 30.
2. A second way you can use the RSI is to determine if there is accelerating or decelerating momentum, along with market divergence.
When the RSI moves higher, momentum is accelerating, and when the RSI moves lower negative momentum is accelerating. When the RSI reverses initially the markets are experiencing decelerating momentum. When the RSI breaks out above prior resistance, accelerating momentum is breaking out which should give you confidence that the underlying price action will break out. The same is true when the RSI is breaking down through support. You should feel confident the negative momentum will carry prices lower.
When the RSI turns, but prices continue to against the RSI – for example, the RSI makes a top and reverses, but prices continue to rise – a divergence is taking place. You should be leery of these moves, as prices and momentum should move in tandem. If you are trying to pick a bottom or top a divergence with an overbought or oversold condition, is a more advanced strategy to employ.
By using the RSI in conjunction with other technicals indicators, you can improve your chances of forecasting the future direction of bitcoin.