What Is RSI? Explaining the Relative Strength Index

The relative strength index (RSI) is a momentum indicator that evaluates the speed and magnitude of recent price movements to assess whether an asset is overbought or oversold. Developed by J. Welles Wilder Jr. in 1978, RSI is calculated on a scale from 0 to 100, with levels above 70 typically signaling overbought conditions and levels below 30 indicating oversold conditions. Traders use RSI to gauge potential trend reversals, confirm market trends and identify divergences between price action and momentum.

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What Is the Relative Strength Index (RSI)?

The relative strength index (RSI) is a technical indicator that tracks the momentum of price movements over a set period, typically 14 trading sessions. It quantifies the balance between recent gains and losses, producing a value between 0 and 100 that traders use to assess buying and selling pressure. RSI differs from trend indicators because it focuses on the strength of price action rather than direction alone, making it particularly useful for identifying shifts in market momentum.

Wilder introduced the concept in his 1978 book, “New Concepts in Technical Trading Systems.” He named it “relative strength index” because it compares the strength of an asset on its up days to the strength of the same asset on its down days. RSI remains one of the most popular tools among traders.

Beyond overbought and oversold conditions, traders watch for RSI divergences, where price action and RSI move in opposite directions. A weakening RSI while prices continue climbing can signal reduced buying pressure, while rising RSI alongside falling prices may suggest that selling momentum is slowing, hinting at a possible trend shift.

How to Calculate and Understand RSI

RSI oscillates on a scale of zero to 100. It is usually depicted graphically.

The formula to calculate RSI is:

RSI = 100 – [100 ÷ ( 1 + (Average Gain During Up Periods ÷ Average Loss During Down Periods ))]

To calculate RSI even more precisely, you can use previous averages when determining current average gain or loss:

Average Gain = [(Past Average Gain) x 13 + Current Gain] ÷ 14
Average Loss = [(Past Average Loss) x 13 + Current Loss] ÷ 14

RSI values above 70 indicates that an asset is becoming overbought and the market is bullish, while an RSI reading below 30 indicates that an asset is becoming oversold and the market is bearish. An RSI of 50 represents neutral conditions.

What Are the Benefits of Using RSI?

While commonly used to detect overbought and oversold conditions, RSI also helps traders refine their strategies in both ranging and trending markets. Understanding its applications can improve trade timing and provide deeper insights into market behavior.

Identifying Overbought and Oversold Conditions

As stated above, RSI charts can help you predict how an asset or market will perform. In general, if you see an overbought, or overvalued, condition, you can expect that there will be a corrective decline in price soon. Oversold, or undervalued, conditions signal that a price increase could be coming. In other words, you should buy a stock when it reaches an RSI of 30 and sell or short when it hits an RSI of 70.

RSI’s Effectiveness in Different Market Conditions

Some traders use more extreme RSI values of 20 for buying and 80 for selling to play it “safe” with more volatile assets. If you want to confirm the trend reversal is happening, wait a little longer. Only buy once the RSI crosses below 30 then starts to rise again. Sell or short when RSI passes 70 then falls back below.

Of course, it can’t be that simple. Markets aren’t that predictable, and each asset moves differently. Some remain oversold or overbought for a long time. While RSI is a powerful tool, it is much more reliable in a ranging market. In fact, it can send misleading signals in a trending market. No matter what the market conditions, you should always combine RSI readings with other indicators to validate reversal predictions. While it’s possible to do so yourself, a financial advisor can help you consider a wide range of market data in making investment decisions.

Spotting Bullish and Bearish Divergences

RSI also help traders identify divergences, which is when the RSI reading does not match an asset’s movement. Bullish, or positive, divergence occurs when an asset reaches a new low in price, and the RSI value does not. Most traders take this as a signal to buy because selling momentum is slowing and the price will likely climb.

Bearish, or negative, divergence, on the other hand, occurs when an asset reaches a new high in price, but the RSI value does not. This is commonly interpreted as a sell signal because buying momentum is slowing and the price will likely drop. Divergences can confirm other signals and indicate when a trend may be ending.

Using RSI to Identify Trend Patterns

Last but certainly not least, RSI helps traders determine and confirm general trends. By trading in the direction of the trend, you can make more money. RSI can show patterns the underlying price chart cannot, like double tops and bottoms as well as support and resistance, that predict price changes further ahead.

Limitations of RSI

RSI is a widely used momentum indicator, but it has limitations that traders and analysts should consider. One key issue is that RSI can remain overbought or oversold for extended periods in strong trending markets, leading to false reversal signals. An asset with a high RSI may continue to rise, just as one with a low RSI can keep declining, making it unreliable for precise timing.

RSI is also less effective when used in isolation. Traders often combine it with other indicators, such as moving averages or volume analysis, to confirm signals. Additionally, RSI divergences – where price and RSI move in opposite directions – do not always lead to trend reversals, as strong trends can override momentum shifts.

Lastly, RSI performs best in range-bound markets, where prices oscillate between support and resistance. In trending markets, adjusting RSI settings or using complementary indicators can help reduce misleading signals.

Bottom Line

The Relative Strength Index (RSI) is a powerful trading tool with many uses. It has remained relevant for more than 30 years despite market changes and the development of more sophisticated trading technology and tools.

You can use RSI to predict market behavior and asset values, but it should only be one indicator in any comprehensive trading strategy. It’s also important not to confuse RSI with relative strength, which compares the performance of different assets.

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