Navigating the markets often requires additional tools that can provide insight into trends. One such tool is the true strength index, which helps traders identify overbought and oversold conditions and quantify the strength of trends. In this FXOpen article, we’ll explore what the true strength indicator’s lines mean, what signals it produces, and its limitations.

What Is the True Strength Indicator?

The true strength index (TSI) is a leading indicator designed to inform traders about market trends and potential reversals. Developed by William Blau, the TSI is a momentum oscillator that integrates the principles of trend direction and momentum.

The TSI aims to determine the true strength of a market trend, hence its name. It primarily serves to identify oversold and overbought conditions, where an asset's price has been pushed to an extreme and a reversal may be imminent. It does this by smoothing out fluctuations, reducing noise and helping traders focus on the overall trend direction.

Furthermore, the TSI incorporates aspects of momentum into its calculations. By evaluating the degree and speed of price changes, it helps to quantify the underlying strength of a trend. This feature makes it a valuable tool for traders seeking to confirm a trend's vigour or anticipate potential reversals.

True Strength Index: Formula

The true strength index is calculated in several steps, incorporating price changes and exponential moving averages (EMAs).

• Compute Price Change: The initial step involves calculating the price change of an asset, which is the difference between the current and previous period’s closing price.
• Calculate Absolute Price Change: This is the absolute difference between the current closing price and the previous period's closing price.
• Compute Smoothed Price Change and Absolute Price Change: For these calculations, use a specified period (usually 25 periods) EMA on both the price change and the absolute price change computed above.
• Calculate Double Smoothed Price Change and Absolute Price Change: Apply a second EMA (typically 13 periods) on the previously smoothed price change and absolute price change.
• Compute the TSI: The final step involves dividing the double smoothed price change by the double smoothed absolute price change, and multiplying the result by 100 to express it as a percentage.
  

In other words, the formula can be described as:

TSI = (Double Smoothed Price Chance / Double Smoothed Absolute Price Change) x 100

The resulting line is known as the TSI. A signal line is also plotted, which reflects a 7 to 137-period EMA of the TSI line. Both lines fluctuate around a zero, or centre, line. Unlike a similar indicator, the relative strength index (RSI), the overbought and oversold levels aren’t fixed.

Instead, they depend on the asset and chosen true strength indicator timeframe. One forex pair, for example, may often reverse beyond +0.5 and -0.5, while another might typically reverse beyond +0.4 and -0.4.

But what are the true strength indicator’s best settings? Many traders prefer to keep the EMAs as their defaults (25 and 13), but some adjust the signal line’s length. A shorter length will provide more frequent signals, while a longer length will produce fewer signals, but they may be more accurate.

How to Use the True Strength Index in Trading

Ultimately, the process of gauging market strength and reversals is improved by the true strength indicator. However, there are several tradeable signals it also produces. In this section, we’ll cover its four primary signals: signal line crossovers, centerline crossovers, breakouts, and divergences.

If you’d like to follow along, head over to FXOpen’s free TickTrader platform and add the true strength indicator to your chart.

Signal Line Crossovers

Firstly, signal line crossovers are key to understanding the indicator. The signal line, an EMA of the TSI line, interacts with the TSI line to generate potential trading signals. When the TSI line crosses above the signal line, it could suggest a favourable condition to initiate a long position. Conversely, when the TSI line crosses below, it might be a good idea to consider selling.

Centerline Crossovers

Next are centerline crossovers. The centerline, represented by zero on the oscillator, assists in identifying shifts in momentum. When the TSI is above the centerline, momentum is positive and could indicate a bullish trend. When it's below, the momentum is negative, potentially signalling a bearish trend. Traders often use this centerline crossover strategy for a directional bias in their trading decisions.

Breakouts and Divergence

Lastly, the TSI can aid in spotting breakouts and divergence – two significant events in trading. When the TSI line breaks through a trendline, it might foreshadow a momentum shift and signal potential trading opportunities.

Divergence, where the TSI and price direction diverge, is also crucial. A bullish divergence occurs when the TSI rises while the price falls, potentially indicating a price increase soon. Conversely, a bearish divergence is when the TSI drops while the price increases, suggesting a possible price drop.

True Strength Index vs Moving Average Convergence Divergence: Differences

Both the TSI and the Moving Average Convergence Divergence (MACD) are momentum oscillators used in technical analysis, but they function and are calculated differently.

The TSI is designed to evaluate the true strength of a market trend by smoothing price changes. Its complex calculation, involving double smoothing with exponential moving averages, reduces signal noise and presents a clearer picture of the trend strength and direction.

On the other hand, the MACD measures the relationship between two moving averages of an asset's price. It calculates the difference between a short-term and a long-term moving average, creating a single line that oscillates around zero. MACD signals are generated through crossovers with a signal line, which is the EMA of the MACD line itself.

While both indicators can help identify potential buy and sell opportunities, their signals will not always align due to their differing calculations. Some traders even combine both the MACD and true strength indicators for intraday trading, since they can help confirm signals of each other.

Limitations of the True Strength Index (TSI)

Despite its utility, the true strength index has several limitations. One key challenge is the occurrence of false signals. For instance, the indicator may cross below the centerline during an uptrend, suggesting a momentum shift, while the price continues to rise. Similarly, frequent signal line crossovers might not provide beneficial trading signals without additional filtering through other analysis methods or indicators.

Another limitation is the reliability of divergence. Divergence can persist over extended periods, providing little insight into when a reversal might occur. Moreover, reversals can occur without divergence, potentially representing missed trading opportunities.

The Bottom Line

In conclusion, the TSI is an effective tool that can be a great addition to any technical analysis arsenal. Its ability to determine the true strength of market trends and provide potential price reversal signals is invaluable in the often unpredictable world of trading. If you’re ready to put your TSI skills into practice, you can open an FXOpen account to gain access to over 600+ markets, while benefiting from low-cost trading and rapid execution speeds. Happy trading!

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