The True Strength Index (TSI) is a dynamic technical momentum oscillator utilized by technical analysts to pinpoint trends and reversals in the market. This indicator assists traders in gauging overbought and oversold conditions, predicting potential trend direction changes through centerline or signal line crossovers, and provides warnings of trend weaknesses through divergence.
Key Takeaways
- Detect Trend and Reversals: The TSI helps in identifying market trends and reversing points.
- Bullish vs. Bearish: The indicator fluctuates between positive (bullish) and negative (bearish) territory.
- Divergence Signal: When divergence occurs with price, TSI might be signaling a potential weakening and upcoming trend reversal.
- Signal Crossovers: A TSI crossing above the signal line suggests a buy, while crossing below indicates a sell.
- Asset-Specific Levels: Overbought and oversold levels differ by the traded asset.
Formula and How to Calculate the True Strength Index (TSI)
To compute the TSI, use the following steps:
- Record price changes and absolute price changes.
- Calculate the 25-period EMA of both the price change and absolute price change.
- Smooth both of these EMAs by applying a 13-period EMA.
- Compute the TSI value by plugging the double-smoothed values into the TSI formula.
1double smoothed PC = EMA25 of PC
2double smoothed absolute PC = EMA25 of ABS PC
3TSI = 100 * (double smoothed PC / double smoothed ABS PC)
Here, PC is the Price Change = Current Close Price - Prior Close Price.
The main skill required is calculating an exponential moving average (EMA).
How the TSI Works
Technical analysis involves researching and evaluating an asset’s past performance to identify potential trading opportunities. Created by William Blau in 1991, the TSI measures price movement strength over time.
The TSI identifies overbought and oversold conditions, marks trend direction changes, and indicates short-term price momentum through signal line crossovers. Levels will vary by the asset, and extreme TSI readings can highlight potential trade points.
How to Interpret the TSI
TSI not only identifies trends but also assists in making sense of different levels, crossovers, and divergence.
Signal Line Crossovers
A signal line crossover indicates a potential trading position. When TSI crosses above the signal line, it suggests a long position, and if it crosses below, it suggests selling. Signal line crossovers should be used in conjunction with other signals for accuracy.
Centerline Crossovers
When TSI crosses above zero, it reflects positive momentum, while crossing below indicates negative momentum. Traders use the centerline to set directional biases—entering long positions above zero, and shorts below it.
Breakouts and Divergence
TSI identifies breakouts and price momentum shifts by observing support and resistance levels. Bullish divergence occurs when TSI rises while the price falls, indicating potential price increases, whereas bearish divergence signals a potential drop.
Divergence, while insightful, should be accompanied by other indicators for precise market timing.
The TSI vs. the Moving Average Convergence Divergence (MACD) Indicator
While TSI smooths price changes to create an oscillator, MACD measures the separation between two moving averages. Both serve to identify trends and trading signals, yet they provide different insights.
Limitations of the TSI
Many signals from the TSI can be false, such as crossing the centerline during an uptrend followed by continued price rise, despite the indicator signaling momentum shift. Frequent signal line crossovers and unreliable divergence can lead to impractical trading cues. Careful filtering and cross-analysis are essential for maximizing effectiveness.
Who Created the True Strength Index?
William Blau, an author and trader, introduced the True Strength Index in the Stocks & Commodities magazine in 1991, describing it as a refined momentum indicator free from high-frequency noise.
What Is Technical Analysis?
Technical analysis, the art of using historical data and indicators to predict market movements, stands in contrast to fundamental analysis, which evaluates an asset’s intrinsic value based on financial and economic factors.
How Do You Calculate the True Strength Index?
- Track price and absolute price changes. Calculate the 25-period EMA for both values.
- Smooth each EMA by applying a 13-period EMA.
- Calculate TSI using:
TSI = 100 * (Double Smoothed Price Change / Double Smoothed Absolute Price Change)
The Bottom Line
The True Strength Index is a versatile oscillator aiding traders in identifying trends and market signals. Due diligence, thorough research, and combining TSI with other indicators and analysis techniques are imperative for making sound investment decisions.
References
- Technical Analysis of Stocks & Commodities. “V.10:5 (214-219): Trading With The True Strength Index by William Blau”.
