True Strength Index

True Strength Index (TSI) – Strategy And Trading Rules

In the ever-evolving world of financial markets, traders are always looking for new ways to understand price movements and indicators like the True Strength Index (TSI) come in handy. What do you know about this indicator?

The True Strength Index (TSI) is a momentum indicator that is based on a double smoothing of price changes. It is an oscillator, swinging between limits of -100 and +100, with 0 as the centerline. As a momentum oscillator, it can be used to identify both the short-term trend direction and overbought/oversold conditions.

In this post, we will take a look at everything you need to know about this indicator: what it is, how it works, and how you can improve your trading strategies with it. We even show you a backtested trading strategy complete with trading rules. Keep reading!

Key takeaways

  • The True Strength Index (TSI) is a momentum indicator;
  • Used to identify both the short-term trend direction and overbought/oversold conditions;
  • The win rate is normally low but offset by a few and large winners;
  • The TSI works most likely best for trending assets (not stocks);
  • We show you a backtested trading strategy for gold.

What is the True Strength Index (TSI)?

The True Strength Index (TSI) is a momentum indicator that is based on a double smoothing of price changes. It is an oscillator, swinging between limits of -100 and +100, with 0 as the centerline. The indicator consists of 2 lines — the TSI line and an exponential moving average of the TSI known as the signal line. It was created by William Blau in the early 1990s.

As a momentum oscillator, it can be used to identify both the short-term trend direction and overbought/oversold conditions. Momentum is bullish when the oscillator is positive and rising. When the oscillator is negative and falling, the market momentum is in the bearish direction. Most traders use the +25 and -25 as the cutoff levels — when the oscillator rises above the +25 levels, it signals a bullish trend (at least in the short term), and when it falls below the -25 levels, it signals a bearish trend.

Please see the graphics further down in the article for some visual images.

How does the True Strength Index (TSI) work?

The true strength index (TSI) works by using a double smoothing of price changes to estimate the true strength of the price momentum. So, it works based on the principle of price momentum, which is the speed at which the price of an instrument changes over a given time.

The unique thing about the TSI is that it applies a double smoothing method (with 2 different moving averages) on the calculated price changes to get a smoother momentum line than most other momentum indicators. This gives a better indication of an instrument’s price momentum.

True Strength Index trading (TSI) strategy – trading rules, backtest, returns, and performance

We have explained the indicator to you, and now it’s time to put the indicator to the test: does the True Strength Index work?

Let’s formulate some trading rules and backtest them. The TSI indicator can be used in many ways, but in this article, we make the following trading rules and we show you the complete Amibroker code:

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We didn’t optimize the settings; we used the standard default settings. Does it work?

We backtest several assets, and it seems to work best for gold (GLD). From GLD’s inception until today, we got the following equity curve:

True Strength Index strategy
True Strength Index strategy

The trading performance and statistics read like this:

  • No. of trades: 211
  • Average gain per trade: 0.64%
  • Win ratio: 37% (!)
  • Max drawdown: 21%

The low win ratio is worth noting, but this is more than offset by the winners, who are three times larger than the average loser.

Why is TSI important for traders and investors?

The TSI is important to traders and investors because it attempts to show the momentum of an asset’s price, which they can interpret to know whether to buy or sell the asset and when to do so.

Interestingly, the indicator is a lot smoother and gives a more accurate signal than most other momentum indicators, as it uses a double smoothening technique, thereby clearly showing when the short-term trend is strong and when it is weak. Traders and investors also use the indicator to identify overbought and oversold conditions in the market, as well as divergences between the price and the indicator.

How is TSI calculated in trading and finance?

In trading and finance, the TSI is calculated by dividing a double-smoothed price change by a double-smoothed absolute price change and multiplying the quotient with 100. Thus, the calculation consists of three steps:

Step 1: Calculating Double Smoothed Price Change

Price Change = Current Price — Prior Price

Smoothed Price Change = 25-period EMA of Price Change

Double Smoothed Price Change = 13-period EMA of 25-period EMA of Price Change

Step 2: Calculating Double Smoothed Absolute Price Change

Absolute Price Change = Absolute Value of Current Price — Prior Price

Smoothed Absolute Price Change = 25-period EMA of Absolute Price Change

Double Smoothed Absolute Price Change = 13-period EMA of 25-period EMA of Absolute Price Change

Step 3: Calculating the TSI

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

What are the key components of the TSI formula?

The key components of the TSI formula are as follows:

  • Double Smoothed Price Change: This is a 13-period EMA of a 25-period EMA of Price Change, which is the difference between the current price and the previous price.
  • Double Smoothed Absolute Price Change: This is a 13-period EMA of a 25-period EMA of Absolute Price Change, which is the difference between the absolute value of the current price and the previous price.

Since both components are a measure of price momentum, their quotient which gives the TSI provides valuable information about the strength or weakness of the short-term. The double smoothening technique helps make the indicator less liable to whipsaws.

When was TSI first introduced in the financial world?

The TSI was first introduced in the financial world in 1991 by William Blau. He first explained it in an article he published in Stocks & Commodities Magazine.

Since then, the indicator has become quite popular among trading communities, and many trading platforms now provide it as part of the standard collection of indicators that come with the platforms.

Can TSI help identify trend strength and direction?

Yes, the TSI can help identify trend strength and direction since it measures price momentum. The indicator uses double moving averages of price changes to measure both the short-term trend direction and the strength of the trend.

The market is bullish when the indicator values are positive and rising and bearish when the values are negative and falling. For most traders, the +25 and -25 are key levels — when the indicator crosses above the +25 levels and keeps rising, it signals a strengthening bullish trend, and when it crosses below the -25 levels and keeps falling, it signals a strengthening bearish trend.

How does TSI differ from other momentum indicators?

The TSI differs from other momentum indicators, such as the RSI, stochastic, and MACD, because it combines the momentum aspect of price movement with a 2-step (moving average) smoothening method to create a measure of price movement that is in better sync with the market ebbs and flows than any of the other momentum indicators that either focus more on price momentum or moving averages.

For example, the RSI and stochastic focus more on momentum (price changes over time), which tends to lead price reversals but often with erratic signals. MACD, on the other hand, focuses more on moving averages, which naturally lags price movements. In the TSI, we have a blend of both the leading momentum aspect and the lagging moving average, thereby offering a more accurate indication of price movements.

What are the benefits of using TSI in technical analysis?

The benefits of using the TSI in technical analysis include:

  • It can show the direction and strength of the short-term trend through the signal line or centerline or personal cutoff level crossover.
  • It shows overbought and oversold conditions in the market when the indicator line reaches a certain level.
  • It can show potential trend weakening through its divergences from the price swings.
  • It can improve the signals from other indicators.

Which trading strategies can be enhanced with TSI?

Many trading strategies can be enhanced with the TSI, but the most common ones are as follows:

  • Short-term trend-following strategies: The TSI can help identify short-term trends with better accuracy.
  • Momentum-based swing trades: These are trades that aim to ride the next impulse wave in the direction of the main trend after a pullback. The TSI can be used to know when a pullback is likely over so as to jump in and ride the next swing.
  • Range-bound mean-reversion trades: In a range-bound market, mean-reversion traders can use the TSI to confirm whether the market is in the overbought/oversold situation before looking for reversal trades.

What are the limitations of TSI in market analysis?

The limitations of the TSI in market analysis include:

  • It can still give false signals: In spite of the double smoothening technique, the TSI does give false signals from time to time.
  • It can still lag the price: As a result of the double-step moving averages, the TSI can lag actual price movements and give late signals.
  • It can’t tell when the market is choppy: The TSI cannot tell when the market is choppy, which is actually the time it’s more than likely to give frequent false signals.
  • It’s not a standalone trading signal: Given all the above limitations, the TSI should not be used as a standalone trading signal. It works better when combined with other analysis tools or price action analysis.

How does TSI handle market volatility and fluctuations?

The TSI uses its double smoothening technique to handle market volatility and fluctuations. The 2-step moving averaging of the price changes helps it produce a smoother indicator line than many other momentum indicators but this only serves to the extent it can.

When the market is extremely volatile and choppy, the TSI could get whipsawed. This is why it is smart to combine it with other indicators that can help identify choppy markets and improve its signal.

What are some common misconceptions about TSI?

Some common misconceptions about the TSI include:

  • TSI signals are always accurate: There is no Holy Grail indicator out there, and the TSI is not one. TSI signals are never always accurate. Sometimes, they get whipsawed.
  • Overbought means sell, and oversold means buy: While overbought/oversold market conditions may indicate an overextended price movement in one direction, it does not mean the price will soon reverse. An oversold reading on the TSI does not mean a buy signal and neither does an overbought reading mean a sell signal.
  • Divergences mean trend reversal: TSI divergences from price swings do not mean an imminent trend reversal. It only shows a weakness in the trend, but that does not mean the trend can’t resume its strength.

How can beginners interpret TSI signals effectively?

To effectively interpret TSI signals, beginners need to focus on specific aspects of the TSI signals. Here are five situations they should be aware of:

  • Centerline: This is the zero line. When the indicator rises above it, the values become positive, meaning that the momentum is positive and the price could keep gaining. The opposite is true when the indicator falls below the centerline.
  • Overbought/Oversold levels: The +80 level is taken as the overbought level. When the indicator rises above it, the price trend may be overextended. The -20 level is taken as the oversold level, so when the indicator falls below it, the downward price action is assumed overextended.
  • Signal line crossover: The TSI has two lines — the TSI line and the signal line. When the TSI line crosses above the signal line in an oversold region, it could be an indication that the price is about to reverse and become bullish. Similarly, when the TSI line crosses below the signal line in an overbought region, it could mean that the price may soon become bearish.
  • Divergence: This is a warning that the existing trend is weakening and could reverse.

What timeframes are suitable for applying TSI?

All timeframes are suitable for applying the TSI. The timeframes you apply the TSI depend on your trading style and personality. If you’re a day trader, you may apply the indicator on the hourly or 15-minute timeframe, and if you’re a swing trader, you would apply it on a higher timeframe — the 4-hourly or daily timeframe. A position trader may use an even higher timeframe.

How does TSI complement other technical indicators?

The TSI complements other technical indicators by showing the direction and strength of the short-term trend, as well as overbought/oversold levels and divergences from the price. How the TSI complements any technical indicator depends on the specific indicator and its weakness.

For instance, when combined with a long-period moving average indicator, which shows the longer-term trend, the TSI helps show the movements of the short-term trends — impulse waves and pullbacks — so you know when to enter the market at the end of a pullback to ride the next impulse wave.

What role does TSI play in risk management strategies?

The TSI does not directly play a direct role in risk management strategies. However, you can use it alongside other indicators or price action analysis to create robust trading strategies with clear entry and exit criteria and risk management parameters, such as position sizing and stop-loss levels.

How do traders use TSI to identify entry and exit points?

To use the TSI to identify entry and exit points, traders have to first formulate a robust strategy based on the indicator’s aspects that appeal to them — which can be centerline crossover, signal line crossover, overbought/oversold levels, or divergences.

For instance, an entry strategy may be to look for a signal line crossover in the overbought/oversold region when the price pulls back to a resistance/support level in a trending market. Then, the opposite could be an exit strategy.

What are some real-world examples of TSI application?

Here are some real-world examples of the TSI application:

Example 1: A buy signal on US30.

The chart below shows the US30 on the hourly timeframe. You can see the market was in an uptrend, as indicated by the white trendline. The strategy is a pullback reversal at the trendline, with the TSI divergence and signal crossover as the entry signal. Notice the bullish hidden divergence (higher low of price with indicator lower low). Other confluence factors are the signal line crossover and the pin bar (hammer) at the trendline.

True Strength Index example
True Strength Index example

Example 2: A sell signal on US30:

The chart below shows a sell signal in the same US30 H1 timeframe. The price was in a downtrend and the price rallied for a while and printed reversal candlesticks. Meanwhile, the TSI signal line crossover happened, followed by a centerline crossover to the negative territory. That’s a sell trade to ride down the next impulse downswing.

True Strength Index indicator
True Strength Index indicator

How can traders avoid false signals when using TSI?

To avoid false signals when using the TSI, traders should combine the indicator with other analysis tools or price action analysis to formulate a robust trading strategy with reliable signals. That would mean backtesting the strategy to be sure it has an edge (it’s profitable).

Another thing to note is that using the indicator on a higher timeframe reduces the frequency of false signals.

What are the best practices for integrating TSI into trading systems?

The best practices for integrating the TSI into trading systems are as follows:

  • Formulate trading strategies using the indicator alongside other analysis tools
  • Have robust risk management parameters
  • Backtest the strategies with their risk management parameters
  • Evaluate your backtesting results to select the strategies that are profitable
  • Forward-test the strategies and choose the ones that are robust enough for live trading
  • Deploy your robust strategies
  • Monitor and evaluate the performance periodically to know when to tweak the systems

How does TSI adapt to different market conditions?

The TSI does not adapt to different market conditions on its own. It’s your job as the trader to know how to use the indicator in different market conditions.

You may have different strategies for different market conditions, so you have to identify each market condition in time to know the strategy that applies and how to use the TSI in that case.

Can TSI be customized to fit specific trading preferences?

Yes, the TSI can be customized to fit specific trading preferences. Since the indicator has many aspects that can be used to create a trading strategy, you can choose how you trade with the indicator based on your specific trading preferences.

If you are a trend-following swing trader, you can use the indicator to know when a pullback is over so you and jump in to ride the next impulse swing.

What resources are available for learning more about TSI?

Some of the resources available for learning more about the TSI are William Blau’s articles in Stocks & Commodities Magazine and financial websites like therobusttrader.com and quantifiedstrategies.com. but nothing beats the tried and tested demo trading, and interestingly, you can easily get the indicator for any platform you’re using.

How do experts optimize TSI settings for maximum effectiveness?

How experts optimize the TSI settings for maximum effectiveness varies from one person to another, but one common thing is to periodically change the parameters in the TSI settings and backtest them to see the one that offers maximum effectiveness.

Then, they trade with those settings until they feel the performance has dropped and they repeat the process again to find the best settings for the new market condition.

What are some common mistakes to avoid when using TSI in trading?

Some common mistakes to avoid when using the TSI in trading include:

  • Approaching the market without first having a backtested trading strategy with positive expectancy
  • Taking overbought/oversold levels and divergences as trading signals
  • Trading without an adequate risk management plan
  • Risking too much per trade because you think your strategy is great
  • Trading in a choppy market
  • Revenge trading
  • Not keeping a trading journal
  • Embarking on your trading journey without getting trading education first

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