Relative Strength Index (RSI) Explained: A Technical Indicator for Identifying Overbought and Oversold Conditions

The Relative Strength Index (RSI) is a widely used momentum oscillator in technical analysis. It helps traders identify overbought and oversold conditions in the price of an asset, potentially signaling price reversals. Developed by J. Welles Wilder Jr. and presented in his 1978 book, “New Concepts in Technical Trading Systems,” the RSI has become a cornerstone indicator for many traders across various markets, including stocks, forex, and cryptocurrencies.

Understanding Momentum Oscillators

Before diving deep into the RSI, it’s crucial to understand the broader category of momentum oscillators. Momentum indicators measure the speed and change of price movements. They oscillate between a set range, providing signals based on the rate at which the price is rising or falling. Unlike trend-following indicators (like moving averages), momentum oscillators are often leading indicators, meaning they can potentially signal changes in price direction *before* the actual price movement occurs.

RSI Calculation

The RSI is calculated using the following formula:

RSI = 100 – 100 / (1 + RS)

Where RS (Relative Strength) is:

RS = Average Gain of Up Periods / Average Loss of Down Periods (during a specified lookback period)

The standard lookback period is 14 periods, although traders can adjust this based on their trading style and the asset being analyzed. “Periods” can refer to any timeframe – minutes, hours, days, weeks, etc. – depending on the chart being used.

Here’s a step-by-step breakdown of the calculation:

1. Calculate the Average Gain and Average Loss: For each period in the lookback period (e.g., 14 days), determine if the price closed higher (gain) or lower (loss) than the previous period. If it closed higher, the gain is the difference; if it closed lower, the loss is the absolute value of the difference. If the close is the same, both gain and loss are 0.
2. Initial Average Gain/Loss: For the first calculation (i.e., after the first 14 periods), simply average the gains and losses separately over those 14 periods.
3. Subsequent Average Gain/Loss: For subsequent calculations, a smoothing technique is used to prioritize recent price changes. This is done using the following formulas:
   • Average Gain = [(Previous Average Gain x 13) + Current Gain] / 14
   • Average Loss = [(Previous Average Loss x 13) + Current Loss] / 14

   Note: The number 13 came from (lookback period – 1).

4. Calculate the RS: Divide the Average Gain by the Average Loss.
5. Calculate the RSI: Plug the RS value into the RSI formula.

Fortunately, most charting platforms and trading software automatically calculate the RSI, so traders don’t need to perform these calculations manually.

RSI Interpretation

The RSI oscillates between 0 and 100. The key levels to watch are:

• Overbought (Typically 70 and above): An RSI reading above 70 suggests that the asset is becoming overvalued and may be due for a price correction or reversal to the downside. It indicates that buying pressure may be unsustainable.
• Oversold (Typically 30 and below): An RSI reading below 30 suggests that the asset is becoming undervalued and may be due for a price bounce or reversal to the upside. It indicates that selling pressure may be exhausted.

It’s important to note that these are general guidelines, not absolute rules. Strong trends can cause the RSI to remain in overbought or oversold territory for extended periods. For instance, during a strong uptrend, the RSI might stay above 70 for a considerable time, and during a strong downtrend, it may remain below 30 for a while. Therefore, it is not wise to use RSI by itself, it has to be used with other indicators.

Divergences

Divergences are another crucial aspect of RSI interpretation. Divergences occur when the price of an asset moves in one direction, while the RSI moves in the opposite direction. This can indicate a weakening of the current trend and a potential reversal.

• Bullish Divergence: Occurs when the price makes lower lows, but the RSI forms higher lows. This suggests that downside momentum is weakening, and a bullish reversal may be imminent.
• Bearish Divergence: Occurs when the price makes higher highs, but the RSI forms lower highs. This suggests that upside momentum is weakening, and a bearish reversal may be imminent.

RSI Centerline Crossovers

Some traders use the 50 level on the RSI as a confirmation of trend direction.

• Bullish Centerline Crossover:When the RSI crosses above 50, it can be interpreted as a bullish signal, suggesting that the average gains are starting to outweigh the average losses. This may indicate that the momentum is shifting to the upside.
• Bearish Centerline Crossover: Conversely, when the RSI crosses below 50, it can be considered a bearish signal, suggesting that the average losses are now exceeding the average gains. This might indicate that the momentum is shifting to the downside.

RSI Swing Rejections

Swing rejections are another valuable pattern to look for when using the RSI. They combine the concepts of overbought/oversold levels and divergences but provide more specific entry or confirmation signals. They do not rely on the price chart; they only rely on RSI behaviors.

• Bullish Swing Rejection:
  • RSI falls into the oversold area (below 30).
  • RSI crosses back above 30.
  • RSI forms a higher low (a “pullback” that stays above 30).
  • RSI breaks above its most recent high.
• Bearish Swing Rejection:
  • RSI rises into the overbought area (above 70).
  • RSI crosses back below 70.
  • RSI forms a lower high (a “bounce” that stays below 70).
  • RSI breaks below its most recent low.

RSI Trading Strategies

While the RSI can be a powerful tool, it’s rarely used in isolation. Most traders combine it with other indicators and price action analysis to create robust trading strategies. Here are a few examples:

1. Overbought/Oversold Reversals

This is the most basic RSI strategy. Traders look for:

• Buy Signals: RSI drops below 30 (oversold) and then rallies back above 30. This is often combined with other bullish signals, such as bullish candlestick patterns or a breakout above a resistance level.
• Sell Signals: RSI rises above 70 (overbought) and then falls back below 70. This is often combined with other bearish signals, such as bearish candlestick patterns or a breakdown below a support level.

Important addition: Always wait for the candle (or the bar based on your timeframe) finishes it’s forming, before entering any position based on RSI.

2. Divergence Trading

Traders look for bullish and bearish divergences to anticipate potential trend reversals:

• Buy Signals: Bullish divergence (price makes lower lows, RSI makes higher lows). Traders will often wait for additional confirmation, such as a break above a trendline or a moving average crossover.
• Sell Signals: Bearish divergence (price makes higher highs, RSI makes lower highs). Traders might wait for a break below a trendline or a moving average crossover for confirmation.

3. RSI + Moving Averages

Combining the RSI with moving averages can provide a more comprehensive view of the market:

• Buy Signals: RSI is oversold (below 30), and the price is trading near a long-term moving average (e.g., 200-day moving average). A bullish crossover of a shorter-term moving average (e.g., 50-day moving average) above a longer-term moving average could provide further confirmation.
• Sell Signals: RSI is overbought (above 70), and the price is trading near a long-term moving average. A bearish crossover of a shorter-term moving average below a longer-term moving average could provide further confirmation.

4. RSI + Support and Resistance

Using the RSI in conjunction with support and resistance levels can help identify high-probability trading opportunities:

• Buy Signals: RSI is oversold, and the price is approaching a key support level. This suggests that the price may find support and bounce higher.
• Sell Signals: RSI is overbought, and the price is approaching a key resistance level. This suggests that the price may encounter resistance and reverse lower.

Adjusting the RSI Lookback Period

As stated before, the standard RSI lookback period is 14. But, different lookback periods can affect the sensitivity of the RSI. A shorter lookback period (e.g., 9 periods) will make the RSI more responsive to recent price changes, resulting in more frequent overbought and oversold readings. A longer lookback period (e.g., 25 periods) will make the RSI less sensitive, resulting in fewer overbought and oversold readings.

There is no “best” setting for the RSI lookback period. It’s a matter of personal preference and depends on your trading style and time horizon. Shorter lookback periods are more suitable for short-term traders, while longer lookback periods are better suited for longer-term investors. You may want to experiment with different lookback periods to find the best, and then back test the strategy on different timeframes.

Limitations of the RSI

While the RSI is a valuable tool, it’s essential to be aware of its limitations:

• False Signals: Like all technical indicators, the RSI can generate false signals, especially in choppy or sideways markets. It’s crucial to use the RSI in conjunction with other forms of analysis.
• Lagging in Strong Trends: While generally considered a leading indicator, the RSI can still lag in very strong trends. The price can continue to rise even when the RSI is overbought, and vice versa.
• Subjectivity: Interpreting divergences and other RSI patterns can be somewhat subjective. Different traders may have different interpretations of the same signals.
• Not Suitable for All Market Conditions: The RSI, like many oscillators, works best in ranging or oscillating markets. In strongly trending markets, it can give premature signals.

Conclusion

The Relative Strength Index (RSI) is a powerful momentum oscillator that can help traders identify overbought and oversold conditions, potential trend reversals, and trading opportunities. By understanding how to calculate, interpret, and use the RSI in conjunction with other technical analysis tools, traders can improve their market timing and potentially enhance their trading results. Remember to always practice proper risk management and combine the RSI with other forms of analysis for a more comprehensive trading approach. Experiment with different settings and strategies to find what works best for your individual trading style and risk tolerance. Backtesting your strategies is crucial for confirming its effectiveness.