The True Strength Index (TSI) is a technical indicator used to determine the strength of a price trend, and for confirming ongoing trends and identifying a weakening trend heading for a reversal. It uses double-smoothed Exponential Moving Averages (EMA) over a specified period to establish the momentum of a trend.
- The True Strength Index (TSI) indicator is a momentum indicator that helps traders identify trend strength (or trend weakness) and potential trend direction changes.
- The TSI is calculated using double-smoothed moving averages of price changes, making it less prone to market noises, thus providing a clearer view of the price and trends.
- Traders can use the TSI in diverse ways, including getting into an established trend, divergence analysis, and determining overbought and oversold conditions.
- It is a lagging indicator and works well with other technical indicators.
This comprehensive guide explores the True Strength Index, how it works, and how you can effectively use it in your trading strategies. We also highlight some of the benefits and limitations of using this indicator. So, let us get right to it.
What is the True Strength Index (TSI) Indicator?
The True Strength Index (TSI) is a technical indicator developed by William Blau in the early 1990s. The inventor spoke about the indicator in the Stocks and Commodities Magazine, a popular publication in that period.
It is designed to measure the strength and direction of price movements, making it a valuable tool for traders seeking to capitalize on market momentum. The TSI is unique in combining multiple smoothing layers to provide a clearer and more responsive depiction of price movements.
The result is an indicator that provides two lines, the TSI and a signal line, running up and down a zero line from a positive and negative territory, and sometimes crossing over each other.
The activities of these lines help traders with trend trading with signal line crossovers. They also help in indicating potential trend direction changes, and divergences. With proper settings, traders can also determine overbought and oversold levels with the momentum oscillator.
How Does the True Strength Index Indicator (TSI) Work?
To portray the momentum of trends effectively, the True Strength indicator starts by evaluating the price change between the current price and the price from a specified number of periods ago. This initial price change helps the indicator to capture price fluctuations occurring in the short term.
The TSI applies two smoothing levels to reduce noise and provide a smoother view of price changes. First, it calculates the 25-period Exponential Moving Average of price change. Then, it calculates another 13-period Exponential Moving Average of the first Exponential Moving Average.
The same double smoothing technique applies to the absolute price change of the asset. This double smoothing using two exponential moving averages is what sets TSI apart from many other indicators.
Finally, TSI obtains its final value by incorporating the double-smoothed price change and double-smoothed absolute price change into its formula. The True Strength Index (TSI) formula is as follows:
- DSPC = Double smoothed price change
- DSAPC = Double smoothed absolute price change
- PCS= Price Change Smoothed
- APCS= Absolute Price Change Smoothed
- PC = Price Change
- APC = Absolute Price Change
- CCP = Current close price
- PCP = Prior close price
The good thing is that the TSI is scaled to make it easier to interpret. Typically, it displays as an indicator line and a signal line oscillating around a central zero line while making indicator-signal lines crossovers. Positive values above the zero line indicate a bullish market bias, while negative values below the middle line suggest a bearish momentum.
How to Use The True Strength Index Indicator in Trading
The most conventional way of using the TSI indicator is to look for a crossover between the two lines. When the TSI crosses above the zero line and moves into the positive territory, then the trend is bullish.
Conversely, when the TSI crosses below the zero line and moves into negative territory, this suggests a bearish momentum. Also, when a zero cross occurs, you can begin to look for opportunities to enter a trade in the direction of the price momentum.
As you can see in the image below, you can use the crossover between the two lines to enter a trade. However, to ensure the chances of success, you can wait for the two lines to cross above the zero line.
In addition, you can look out for divergence opportunities between the TSI and price action. Like the Relative Strength Index (RSI) and MACD divergence, the same occurs when the TSI direction differs from the price direction.
Bullish divergence happens when the price makes lower highs, but TSI makes higher highs, suggesting a potential price action reversal to the upside. On the other hand, a bearish divergence occurs when the price makes higher highs, but the TSI makes lower highs, indicating a possible relapse to the downside. So, you can use divergence as an early warning sign to get into a new trend.
As you can see in the chart above, the EUR/USD falls while the indicator rises. This suggests a trading opportunity for a long-buying position.
Finally, the TSI can also help identify overbought and oversold levels. When the TSI reaches exceptionally high levels, it may suggest that an asset is overbought and due for a correction. Conversely, very low TSI readings may indicate an asset is in oversold levels and could be primed for a bounce back.
True Strength Index Indicator Trading Strategy Tutorial
Now, let us consider a practicable way to generate trade signals in the market using the True Strength indicator. As stated before, there are several strategies to trade with the TSI. However, in this example, we look at a TSI-signal line crossover.
True Strength Index Indicator Line Crossover
The idea behind this strategy is to watch out for signal line crossovers of the TSI line. A crossover between the TSI and signal lines points us to the new trend’s direction. When the indicator line (blue) crosses above the signal line (red), this suggests a bullish momentum, so you should buy. Conversely, when the indicator crosses below the signal line, then you should sell. To demonstrate, we apply this example on a daily timeframe of the EUR/USD pair.
1. Launch your True Strength Index indicator below the price chart. The default settings are the 13-period and 25-period SMAs.
2. Identify crossovers of the TSI line over the signal line. As you can see, the TSI is quite a reliable indicator as it provides accurate trading signals. You get a buy signal when the True Strength Index crosses above the signal line. You also get sell signals when the reverse takes place.
3. Set your stop loss levels based on your position size and standard risk management practices. In this example, we do 50 pips before entry level.
4. Take some profits when the line crossover reverses. Continue to trail stop to ride along the trend subsequently.
True Strength Index (TSI) Indicator – Pros and Cons
The True Strength Index (TSI) indicator is functional for identifying new trends, getting into a prevailing one, and predicting trend reversals. It effectively supplies beneficial insight into trend momentum, giving traders a comprehensive guide into market dynamics and helping them make informed decisions. However, it does present some limitations that cut back on its efficiency. Some benefits and limitations of the TSI are discussed as follows.
Benefits of Using the True Strength Index Indicator
The True Strength Index indicator quickly points you to trading signals by identifying prevailing and new trends in the market. These opportunities can be further vigorously analyzed using other tools before entering a trade. The main benefits of using the TSI are that it’s extremely easy to use, and it provides reliable trading signals. Some benefits of the True Strength Index indicator are listed below.
- The True Strength Index indicator offers a clear view of momentum and trend direction, making it valuable for trend-trading traders.
- It helps identify divergence and provide early warnings of potential trend reversals using oversold and overbought levels.
- The double smoothing activity of the TSI reduces noise, making it less prone to providing false signals.
- It is also compatible with more indicators and technical analysis tools.
- Like other momentum oscillators, it’s best when used in trending markets.
Limitations of the True Strength Index Indicator
To bolster the rate of expected positive outcomes and minimize loss, consider integrating the TSI with extra indicators, such as support and resistance levels or the Average True Range indicator. This is owing to some limitations that accompany its usage. We highlight some of these limitations below.
- Like many momentum indicators, the TSI is a lagging indicator, which may not provide signals at the beginning of a new trend.
- The double smoothing calculation makes it complex for some traders to grasp easily.
- TSI is most effective with other technical indicators and technical analysis tools.
- Just like many other indicators, it’s not beyond giving a false signal..
- The True Strength Index (TSI) is a powerful momentum indicator used in trading to asses trend strength and possible reversals.
- TSI is calculated using double smoothing averages, which reduces noise and provides more precise trade signals.
- Traders can use TSI for trend following through signal line crossovers, divergence analysis, and identifying overbought and oversold conditions.
- Combining TSI with proper risk management is essential for successful trading.
Frequently Asked Questions About Trading the TSI Indicator
The following are some of the most frequently asked questions about the True Strength Index Indicator.
What does the True Strength Index measure?
The True Strength Index measures the strength and direction of price action in the financial markets. It achieves this by evaluating and smoothing price changes, making traders see if an asset is experiencing a bullish or bearish momentum.
What are the best settings for the True Strength Index?
The optimal settings for the True Strength Index can vary depending on the trader’s strategy and the asset being traded. However, commonly used settings are a short period of 13 and a long period of 25. Traders may alter these settings to suit their trading preferences and timeframes.
Is the True Strength Index a leading or lagging indicator?
The True Strength Index is primarily considered a lagging indicator because it relies on past price data to calculate its values. It may not provide signals at the beginning of a trend, but it effectively identifies the strength and direction of an established trend. Many professional traders use it with other leading or lagging indicators to make better-informed trading decisions.