Investing and trading in the stock market is all about making informed decisions based on price action and certain combinations of indicators. Relative strength index (RSI) is one such indicator that is widely used across the world by both astute and not-so-seasoned traders and investors.
This article will guide you through the basics of RSI focusing primarily on interpretation and practical uses of the indicator and will skip non-essential theoretical parts.
What is Relative strength index (RSI)
RSI is a momentum oscillator that was developed by J. Welles Wilder Jr. and was described in a book published in 1978.
RSI indicates the pace with which the price is moving and it oscillates between two levels, 0 and 100. It shows the strength of price movement, that is, how fast or slow the price of a stock is moving.
Additionally, it also indicates whether a stock is overbought or oversold which helps traders take positions in the trade. RSI below 30 indicates the stock is oversold and a reading above 70 indicates the stock is overbought. I will talk about these points in detail later on in the article.
What does RSI look like in a Chart?
As you can see in the picture above an RSI looks like a line graph in a chart and is plotted below the price chart. Further, this line oscillates between two levels, 0 and 100. Two other levels , 30 and 70, have also been marked in the chart which corresponds to oversold and overbought conditions respectively. Additionally, there is a third level of 50 which has been marked which is the midpoint of these two levels (30 and 70). This level signifies a state of balance between the buyers and sellers.
Which RSI setting should one use in a chart?
The default RSI setting in most charting software is 14. This setting is most widely used as well and works fine for most of the traders.
However, some short term trader use shorter period settings like 7 or 9. This shorter period setting enables them to get faster signals but the trade off is false signals causing losing trades.Conversely, many long term trader prefer settings of 21 or above to reduce false signals and noise.
The best thing to do is to stick to the default settings or try out different settings and use the one that works well for you.
How is the Relative strength index (RSI) interpreted?
Primarily RSI is used as a gauge to measure momentum and to find oversold and overbought conditions. Moreover, finding Price-RSI divergences allows you to predict possible reversals. This is discussed below.
1) Overbought (RSI > 70)- RSI moving above 70 suggests that the price is overstretched on the upside and that a correction or reversal might be on the horizon. However, this is not a sell or sell short signal as the RSI can remain above 70 levels for extended periods if bullish sentiments are high.
2) Oversold (RSI < 30)- RSI moving below 30 indicates that the price is overstretched on the downside and a pullback or reversal to the upside is imminent. However, this again should not be inferred as a buy signal as RSI can remain below 30 for longer periods especially if the downtrend is strong.
3) Momentum (RSI crossing above or below 50)- In an uptrend, RSI crossing above 50 level indicates a strong momentum towards the upside while in a downtrend RSI crossing below 50 can be inferred as strong momentum towards the downside. Some technical analyst, however, opine that RSI crossing above 60 should be viewed as strong momentum on the upside and RSI coming below 40 should be inferred as strong momentum on the downside.
Notice in the image above that the stock is in uptrend and each time RSI crosses above 50 from below the stock price shows accelerated movement towards upside. Shown in the image with red dots.
Practical uses of Relative Strength Index (RSI)-
1) To confirm the trend of a stock-
RSI can be used to confirm the underlying trend in a stock. In an uptrend, RSI largely remains above the 40 level and frequently touches the 70 level mark. Similarly in a downtrend, RSI largely remains below the 60 level and frequently touches the 30 level mark.
Let's understand this with the help of charts.
In the image shown alongside you will notice that RSI remains below 60 for the most part and frequently touches the 30 level mark when stock is in a downtrend and goes above 60 once stock price picks up and trend is reversed.
2) To trade Reversals through RSI divergences-
Divergences occur when the price moves in one direction and RSI fails to follow the suit. For example, if a stock makes a new low but RSI fails to makes a higher low instead then we say there is a bullish divergence between RSI and price. Similarly, if the price makes a new high and RSI makes a lower high there is bearish divergence between price and RSI.
Divergences signify that the existing trend is losing momentum and a reversal or pullback might be on the horizon. Let's understand this concept with a chart.
In the above chart, the stock was in a downtrend and the price made a lower low as shown through the blue trend-line in the upper pane, but RSI made a higher low (lower pane). Subsequently, the stock reversed the trend direction and went up. This is a bullish divergence.
Learn more about RSI divergences in my post- What is RSI divergence and how to trade divergences?
3) To validate Buy/Sell signals given by other indicators-
RSI can also be used to differentiate between false and genuine buy/sell signals given by other indicators.
For example, a price crossing above a moving average is considered a buy signal but if you enter a trade based solely on this signal there would be higher chances of losses. But once you include RSI in the analysis, chances of a successful trade is increased. Price crossing a moving average and simultaneously RSI above 50 would be a better signal to trade with lesser chances of whipsaws.
4) Signal trend reversals through RSI range shift-
RSI is a leading indicator and it signals a change in market sentiments or momentum and trend early through RSI range shifts. For example, when RSI, after being in a bearish range for a while crosses above 70 into bullish RSI range, this might be an early signal that the prevailing downtrend is losing steam and an uptrend might be on the horizon.
5) Signal trend continuation through hidden divergences-
While the regular divergences, we talked earlier, signal a reversal, another kind of divergences called 'Hidden Divergences' signal continuation of the trend. This has been covered in detail in separate post- What is Hidden RSI divergence and how to trade it?
The bottom line-
The Relative Strength Index (RSI) is a widely used momentum indicator that helps traders and investors understand price strength, momentum, and potential reversal zones. This article explained RSI in a simple, practical manner—focusing on how to interpret it rather than on heavy theory.
You learned how RSI identifies overbought and oversold conditions, gauges momentum using key levels like 30, 50, and 70, and helps confirm trends.
The article also covered powerful RSI-based techniques such as trading regular and hidden divergences, validating signals from other indicators, spotting early trend reversals through range shifts, and confirming trend continuation. When used correctly, RSI becomes a versatile tool that improves decision-making and reduces false trading signals.
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