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Technical Studies #1: Using the RSI for Coffee Trading

One of the most useful #TechnicalAnalysis indicators for #commodities in general, and the #coffeemarket in particular, is the Relative Strength Index (RSI). In this article, we will discuss what this indicator is, how it is constructed, and how it is interpreted when reviewing the #market.


If you are interested in learning more about technical analysis, this indicator (along with many others) are taught in detail as part Day 3 of the Coffee Trader's Course.



Why should you care about the RSI?


$Coffee is a rapidly changing market with a lot of $spec involvement and sentiment can (and does) change quickly. This is why it is essential to have quick, easy to read #momentum indicators like the RSI.


What is the Relative Strength Index?


This indicator is an #oscillator (oscillates between 0 and 100) used to evaluate market momentum (rate of rising or falling prices) over a given period.


Traditionally a 14-day period is used, usually days, but can also be hours, weeks, etc.


This indicator calculates market momentum by creating a ratio of average gain vs average loss periods, in other words the “relative strength” of up days vs down days.


The math for how it is calculated is not super important to know since (as it is calculated for you by software), but it is important to understand the logic.



The RSI is one of many indicators created by the famous Technical Analyst, J. Welles Wilder, who believed that prices would become “overbought” when they moved up very rapidly or conversely “oversold” when they sold off rapidly. The levels he identified for overbought and oversold were 70 and 30 respectively.


How to Interpret the RSI


While the RSI indicates a #reversal when the market is overbought or oversold, keep in mind that a #bullish market can maintain a strong (or overbought) RSI for some time, so it is prudent to look for confirmation. The primary way to confirm a reversal in trend is to look for when the RSI crosses out of an overbought or oversold condition.


As an example, let’s use #KCK22 prices. In the picture below (the July coffee frost), we can see a rally on prices between July 12 and 26 (see red square).

The 14-day RSI (green line in the bottom section of the below chart) had a large increase in a small space of time, reaching 70 and almost 80. This indicates that the market was overbought. On July 29th, the RSI crossed out of overbought and the next day the market saw a big pullback on prices.





Note that a signal does not indicate that prices will stay low, but only an indication that at that particular moment the market is overbought and is due for a correction.


Another way to analyze the RSI is by range. During uptrends, the indicator tends to stay in a higher range (40 to 80) compared to downtrends (20 to 60). A shift in this range indicates a shift in trend momentum.


A good example we have right now is #KCH22, which is in a #BullMarket. If we take a look at the 14-day RSI, we can see it’s in elevated levels for the past weeks, indicating strength in the current bull momentum.





It is important to emphasize that the RSI alone is not a good way to make trading decisions and come to concrete conclusions.


Though useful for quantifying momentum, it can give false signals. For this reason, it is best to use the RSI as part of a suite of indicators and as a complement to fundamental analysis.


Conclusion


To summarize this indicator in a few sentences, we can say the following:


During an uptrend, the RSI will likely stay between 40 and 80, frequently hitting 70. For a downtrend, it will trend between 20 and 60 frequently hitting 30. When the market is overbought (>70) or oversold (<30) and comes out of the extended zone, the indicator suggests a correction is imminent.


This tool is simple to use and gain insights about market strength, but its simplicity is reason to be cautious!


Relying on the RSI is not an excuse to ignore what’s going on in the fundamentals. It is, however a great way to sense when a trend may be shifting, and that will be a great help to earn money in the coffee market.


Let us know if there are any other indicators that you would like to see us discuss!