Relative Strength Index (RSI)

A classic momentum oscillator that helps traders spot overbought and oversold conditions before price reversals unfold.

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Key Takeaways

• RSI oscillates between 0 – 100; readings above 70 often flag overbought, below 30 flag oversold.
• Divergences between RSI and price can foreshadow momentum shifts before trend reversals.
• Adjusting the look-back period makes RSI more sensitive (shorter) or more stable (longer) to recent price action.

1. Concept & Origins

Developed by J. Welles Wilder Jr. in 1978, the Relative Strength Index measures the velocity of price moves by comparing average gains to average losses over a set period. Wilder designed RSI to solve a common trader dilemma: When is a trend stretched far enough to anticipate a reversal?

2. Mathematical Intuition

RSI transforms raw price changes into a bounded 0–100 oscillator. By normalising the ratio of up-moves to down-moves, it quantitatively captures bullish or bearish momentum extremes without drifting over time.

3. Indicator Anatomy

RSI consists of a single line oscillating between 0 and 100. Key reference zones are the 30 (oversold) and 70 (overbought) levels, though many traders customise these thresholds.

4. Calculation Guide

4.1 Formula

\(\displaystyle \begin{aligned} RS &= \frac{\text{Average Gain}_{n}}{\text{Average Loss}_{n}}\\ RSI &= 100 - \frac{100}{1 + RS} \end{aligned} \)

4.2 Worked Example

Assume the last 14 sessions produced total gains of $7 (≈ 0.5 per day) and total losses of $3 (≈ 0.21 per day). Average Gain = 0.5, Average Loss = 0.21 → RS ≈ 2.38. RSI = 100 − 100 / (1 + 2.38) ≈ 70.4, signalling a potentially overbought market.

5. How to Read the Signals

5.1 Bullish

RSI crosses up through 30 or 40, or bullish divergence (price makes a lower low while RSI makes a higher low).

5.2 Bearish

RSI crosses down through 70 or 60, or bearish divergence (price prints a higher high while RSI fails to confirm).

5.3 Confirmations & Common Pitfalls

Pair RSI with volume or trend filters (e.g., 200-day SMA) to avoid counter-trend signals during strong trends. Beware of multiple false crosses when markets are range-bound with low volatility.

6. Chart & Interpretation

On the AAPL chart:

• Bullish signal: RSI rebounded above 30 in Jun 2022, aligning with the price bottom that month.
• Bearish signal: RSI slipped below 70 after peaking in Dec 2024, preceding a multi-week pullback.

7. Parameter Sensitivity

Shorter look-backs (e.g., 7) make RSI react faster but increase noise; longer windows (e.g., 21 or 28) smooth readings but delay signals. Traders often tighten overbought/oversold thresholds when using shorter periods to reduce whipsaws.

8. Practical Uses & Strategy Recipe

Pseudo-code Example:
If RSI(14) crosses above 30 and price is above the 200-day SMA, enter long; exit when RSI(14) crosses below 70 or price closes below the 200-day SMA.

10. Best Practices & Limitations

9.1 Best Practices

• Use dynamic thresholds (e.g., 40/60) in strong up- or down-trends.
• Confirm RSI signals with volume spikes or candlestick patterns.
• Combine RSI divergences with support/resistance zones for higher conviction.

9.2 Limitations

• Prone to false signals during sideways consolidation.
• Overbought readings can persist for weeks in powerful bull runs.
• RSI does not quantify how far price might move—only momentum extremes.

10. Related Indicators

• Simple Moving Average (SMA)
• Exponential Moving Average (EMA)
• Moving Average Convergence Divergence (MACD)
• Stochastic Oscillator
• Stochastic RSI

11. Further Reading & References

• Wilder, J. W. New Concepts in Technical Trading Systems
• Murphy, J. J. Technical Analysis of the Financial Markets
• Internal Tinker Tailored deep dive: “RSI vs Stochastic Oscillator – Momentum Exhaustion Analysis.”