True Strength Indicator: How to read it and how to use it
Do you know what the True Strength Indicator is? If you don’t, we’ll tell you.
- What is the True Strength Indicator?
- How to read the True Strength Indicator
- How is the True Strength Indicator calculated?
- How to use the True Strength Indicator
- The drawbacks
What is the True Strength Indicator?
The True Strength Indicator, or the True Strength Index, is one of a range of data tools which can be used to measure the strength of a market. What makes the True Strength Indicator different is that, ideally, it can be used to see if a particular stock is being overbought or oversold.
This gives traders the opportunity to know what is worth buying and what is worth selling ahead of a likely trend reversal, meaning they can keep ahead of the curve.
The True Strength Indicator was created in the early 1990s by William Blau, who was an electrical engineer before he became a trader. Blau first published his work on the TSI in the journal Technical Analysis of Stocks & Commodities in 1991.
If you look at the True Strength Indicator, you will see that there are three lines. One is fixed to a point and the other two go up and down. The fixed, horizontal, line is called the zero indicator. The other two are called the plots. It is what the plots do that help traders use the TSI to make decisions.
The TSI can be used to measure any sort of market so, although we will be talking about stocks here, you can use the TSI to gain some insights if you want to trade commodities or cryptocurrency.
How to read the True Strength Indicator
As we have seen, there are three lines in the True Strength Indicator. We are interested in the two lines that move up and down. These lines are the plots.
You will see that when they move, they sometimes cross over the middle line, or zero indicator. You want to see whether the lines are above the indicator, which means that the stock is moving upwards overall, or if they are below the indicator, which means that it is on a downward trend. If you look closer at the lines, when they reach a sharp point, that means that they are either overbought (if they are pointing upwards) or oversold (if they are pointing downwards).
It’s worth mentioning at this stage that just because something is overbought or oversold, that does not necessarily mean the market is about to change course. All it means is that we can assume that things have gone further than they should have quicker than they should have.
This can suggest that a change in trend is either happening or is about to happen but, equally, the stocks could continue on their current course. If you use a True Strength Indicator strategy for trading that purely relies on the TSI, then you are not going to get the whole picture.
How is the True Strength Indicator calculated?
In order to calculate the True Strength Indicator, you need to do the following things.
First, you will need to work out the change in price across two periods. Then, you will want to find the average of this over 25 periods. This process is called the first smoothing. You will then want to find the average of that change over the space of 13 periods. This is called the second smoothing, and means, to use the technical term, that it has been double smoothed.
You will then want to do the same thing with the absolute price change. After that, divide the double smoothed price change by the double smoothed absolute price change and multiply that by 100 and you’ll end up with the True Strength Indicator.
If you want to put it in a True Strength Indicator formula, it looks like this
How to use the True Strength Indicator
Let’s take a look at a price chart with a True Strength Indicator running underneath it.
We can see that, in this case, the peaks and troughs in the main chart line up pretty well with the ones in the True Strength Indicator. This is something the TSI does well. We can also see marks where it reaches a sharp peak, which are the points where traders might consider the stock to be either overbought or oversold.
We can also see that there is an upturn at the end, which might suggest that the market is moving in an upwards direction. In other words, it was bearish but might just be starting to become bullish.
No tool for reading the markets is going to be perfect. The True Strength Indicator is good, but it does have its faults. For instance, there is always the possibility that it can deliver false signals when it comes to the overall direction of the market and whether stocks are overbought or oversold.
If you want to use the True Strength Indicator, you should remember that the prices of stocks can go down as well as up, and never invest more than you can afford to lose. You should do your own research and use a variety of tools, rather than just one, for market analysis.