In the previous blog post, we discussed the basics of technical analysis (see Part 1). The supporters of this type of analysis believe that the price action doesn’t occur randomly the historical trends and patterns repeat over time.
We briefly presented three of the most basic indicators used by traders – moving average, volume, and bollinger bands. This article will introduce other indicators, namely the Relative Strength Index (RSI) and the Moving Average Convergence / Divergence (MACD), as well as the open-high-low-close (OHLC) type of bar charts.
Relative Strength Index (RSI)
The RSI is a popular technical indicator from the momentum indicators family which measures the current price strength and compares it to previous prices. Developed by Wilder Jr., a US-based technical analyst, it essentially compares the bullish and bearish price momentum as the readings move between two extremes – overbought and oversold. Below you can see the RSI applied on the BTC/USD chart.
Relative Strength Index sample (Source: TradingView)
As you can see in the chart, the readings move between 0 and 100 readings. Any move outside of the 80 and 20 readings is regarded as extreme. A trip north of 80 signals the asset is overbought and a reversal may take place soon. The move below 20 signals the asset is oversold and the trend may reverse upwards. Although the standard setting levels are 70 and 30, better use 80 and 20 due to the higher reliability. However, you should know that the 80 – 20 setting may reduce the occurence of buy / sell signals generated by the indicator.
Moving Average Convergence / Divergence (MACD)
As another member of the family of momentum indicators, the MACD measures the relationship between two exponential moving averages (EMA) – 26 EMA and 12 EMA. The EMA differs from the simple moving average (SMA) in a way that it adds more weight and importance to the most recent data.
You can calculate the MACD simply by deducting the 26-period EMA from the 12-period EMA. It consists of three main elements: the 12-period and 26-period exponential moving averages (MACD), a 9-period EMA (the signal line). In addition, traders also use histogram, which is calculated by deducting the signal line from the MACD reading. In the chart below, you can see the MACD (the blue line at the bottom of the chart) and the signal line (the orange line at the bottom of the chart).
Chart 2. Relative Strength Index sample
The MACD is a more versatile indicator than the RSI. Its readings show three different developments: Crossover, histogram, and divergence. A fall of the MACD below the signal line generates a bearish signal and vice versa – signal line dropping below the MACD line gives a bullish signal. These two developments relate to the so-called MACD crossovers, a point on the chart in which a security and an indicator intersect.
The histogram (green and red readings) measures the distance between the MACD and its signal line, in order to help you identify the momentum (bullish or bearish). Finally, the divergence shows the difference between the direction of the price and the MACD. A bullish divergence occurs when the MACD registers two higher lows, which is in contrast to two descending lows on the price. Contrary to that, bearish divergence shows the price action is moving upside while the MACD trends lower.
The OHLC is a type of bar chart used by traders to gauge the market momentum. It shows four major data points – open, high, low and close. As you can see in the chart below, the price bar consists of one vertical line and two short horizontal lines, where the one going left shows opening price and the one extending to the right shows the closing price of an asset. If it’s a bullish price bar, the right horizontal extension will be above the left as the price closed higher and vice versa.
OHLC chart sample
Essentially, the bigger the difference between the open and close shows a strong momentum as the price opened at one side and closed at the other side of the bar. On the other hand, the close proximity of open and close data points signals indecision or weak momentum.