Understanding the True Strength Index (TSI)

In this article, we will discuss

• What is the True Strength Index?
• What are the Components of the True Strength Index?
• Interpreting the True Strength Index
• How is the True Strength Index Used?
• Conclusion

Technical analysis of an asset gives you insights into its potential price movements. It involves candlestick patterns and a host of indicators to determine market sentiment and future trend directions.

One of the many technical indicators you can use when trading in an asset is the True Strength Index (TSI). In this article, we are going to delve into this particular indicator, closely examine the various constituents and learn how to interpret the signals it generates.

What is the True Strength Index?

Developed by William Blau in the 1990s, the True Strength Index (TSI) is a momentum-based oscillator used to measure the strength of an asset’s price movement. That said, the TSI is also widely used to identify overbought and oversold conditions and potential trend reversals.

One of the primary advantages of the True Strength Index is that it is far more comprehensive and accurate than other momentum-based oscillators, such as the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD). This is because the TSI considers both price momentum and volatility smoothing in its calculation.

What are the Components of the True Strength Index?

The True Strength Index (TSI) moves between +100 and -100 with the centre line placed at zero. The indicator has three primary components - a Price Momentum Line, volatility smoothing and a signal line. Here is a comprehensive overview of each of these components.

• Price Momentum Line (PML)

The Price Momentum Line (PML) indicates the momentum of price changes in an asset. It is calculated by subtracting the closing price of the previous day from the closing price of the present day.

• Volatility Smoothing

The TSI applies a double smoothing technique to the PML using two Exponential Moving Averages (EMAs) of different periods. This ensures that short-term market noise and false signals are filtered out.

• Signal Line

The signal line is derived from the final PML (after volatility smoothing) by applying another Exponential Moving Average. It provides insights into the trend direction and potential reversal points.

Interpreting the True Strength Index

As a trader, you must know how to interpret the TSI to make effective trading decisions. Here is how you can derive insights from the strength index.

• TSI Reaching Extreme Levels

As you already know, the TSI moves between a scale of +100 and -100 with the centreline at zero. Based on the movement of the TSI, you can easily determine overbought or oversold conditions.

For example, if the indicator moves towards the positive extreme, say +80, the asset is said to be overbought. On the other hand, if the indicator moves towards the negative extreme, such as -70, the asset could be oversold. You can use this information to determine potential trend reversal points.

• TSI-Price Divergences

Comparing the True Strength Index with the actual price movement of an asset to identify divergences can give you insights into possible trend reversals.

For example, a positive TSI-price divergence happens when the asset’s price makes lower lows and the TSI makes higher lows. Such a situation could potentially signal an impending bullish reversal. Meanwhile, a negative TSI-price divergence happens when the asset price makes higher highs and the TSI makes lower highs. This could indicate a potential bearish reversal on the cards.

• TSI-Centreline Crossovers

To identify entry and exit signals, you can also compare the technical indicator with the zero centreline. For instance, if the TSI crosses above the zero centreline, a bullish signal is generated. On the other hand, if the TSI crosses below the zero centreline, a bearish signal is generated.

However, before entering into a position based on such crossovers, it is advisable to use other technical indicators to confirm the change in trend direction. This way, you can reduce the chances of your positions losing value due to false signals or adverse market movements.

How is the True Strength Index Used?

The True Strength Index (TSI) has a wide range of use cases. Let us explore some of the popular ways in which you can use the index.

• For Trend Confirmations

The TSI can be used to confirm existing trends in an asset. For example, if the strength index is rising along with the asset price, an uptrend is said to be confirmed. Conversely, if the index is falling along with the asset price, a downtrend is said to be confirmed.

• For Spotting Entry and Exit Signals

You can also actively look out for TSI-price divergences and TSI-centreline crossovers to determine the right point of entry and exit for a trade. For instance, you could enter into a short position if the TSI crosses below the centreline and is falling rapidly. Or, you could enter into a long position if the index is deeply in the oversold region.

• For Trade Risk Management

You also use TSI as part of your trading strategies to manage risk. For example, you can adjust your position sizes and stop-loss points depending on the strength of the trend. If the True Strength Index indicates a strong uptrend, you can increase your position size and set wider stop-losses.

Conclusion

The True Strength Index (TSI) is a very useful tool for determining the strength of a trend, market momentum, reversal points and potential entry and exit signals. Although other technical indicators such as the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD) also help measure price momentum, the TSI holds a slight edge over them. This is due to the double volatility smoothing technique that the index uses to filter out noise.

That being said, the TSI is not flawless and may occasionally generate false signals. It is important to always use the index with other indicators and chart patterns to increase the trade’s success rate. Also, remember to have strong risk management measures in place when entering into any kind of position. This could potentially reduce the negative impact on your trades due to adverse market movements.

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