What is Relative Strength Index (RSI) | How to Trade

The RSI, or Relative Strength Index, is a momentum oscillator introduced by J. Welles Wilder in his 1978 book “New Concepts in Technical Trading Systems.” This technical indicator measures the speed and change of price movements, oscillating between zero and 100. It is commonly used to identify overbought or oversold conditions in a traded security.

What it is and what it shows
The RSI calculates the relative strength of a security’s price performance, aiming to identify conditions where it might be overextended, either to the upside (overbought) or downside (oversold).

Here’s how the RSI is calculated:

RSI = 100 – (100 / (1 + RS))Where: RS = Average of ‘n’ days’ up closes / Average of ‘n’ days’ down closes Typically, ‘n’ is set to 14 periods, which can be days, weeks, months, or even an intraday timeframe.

The resulting number will range between 0 and 100. Generally:

• An RSI above 70 suggests that a security might be overbought and could be primed for a price pullback or correction.

• An RSI below 30 suggests that a security might be oversold and could be ripe for a price bounce or recovery.

How to trade it
The RSI is versatile and can be used in various trading strategies:

1. Overbought and Oversold: The most basic and common way to use the RSI is to identify potential buy or sell opportunities when a security becomes overbought (RSI above 70) or oversold (RSI below 30). However, just because a security is in overbought territory doesn’t mean it will reverse immediately, and the same goes for oversold conditions.

Example: If a stock has an RSI reading of 78, some traders might consider it overbought and anticipate a potential pullback.

2. Divergences: Divergences between RSI and price action can be strong signals. Bullish divergence occurs when the price makes a new low, but the RSI makes a higher low. This might indicate an upcoming upward reversal. Conversely, bearish divergence occurs when the price makes a new high, but the RSI makes a lower high, indicating potential downside.

Example: If a stock makes a lower low, but RSI forms a higher low, it could suggest weakening downward momentum and a potential reversal to the upside.

3. RSI Trendlines and Breakouts: Similar to price charts, traders can draw trendlines on the RSI chart. Breakouts or breakdowns from these trendlines can be used as potential trade signals.

Example: If the RSI is trending down and breaks above a descending trendline, it might indicate a shift in momentum and a potential buy signal.

4. Centerline Crossover: When the RSI crosses above the 50 level, it can be considered a bullish signal, and when it crosses below, a bearish signal. This can be an indication of a shift in the overall trend.

Example: If a stock’s RSI moves from 45 to 55, it crossed the centerline, suggesting increasing bullish momentum.