Definition
Developed by J. Welles Wilder in 1978, RSI compares the magnitude of recent gains to recent losses over a lookback (typically 14 periods). Values above 70 traditionally signal 'overbought' conditions (potential reversal or pullback); below 30 signal 'oversold' (potential bounce). Divergence between price and RSI — price making new highs while RSI does not — is a classic reversal signal used by technical traders. RSI works best in ranging markets and can stay 'overbought' for extended periods during strong trends, generating false sell signals. It should not be used in isolation; combining with trend indicators (like the 200-day MA) improves signal quality.
RSI = 100 − (100 / (1 + RS))
RS = Average Gain / Average Loss over N periods (typically N=14). Gains and losses are averaged separately.
Example
If a stock rallies for 14 days with average gain of $2 and average loss of $0.50: RS = 4, RSI = 100 − (100/5) = 80. This reading above 70 flags overbought — a typical spot for short-term traders to book profits or tighten stops.
Frequently Asked Questions
Is RSI above 70 always a sell signal?
No. Strong uptrends can keep RSI above 70 for weeks. RSI works best combined with trend context — a 'sell overbought' signal is much more reliable during a range-bound market than a trending one.
What lookback period should I use?
14 periods is the default and most widely used. Shorter (7) is more sensitive but noisier; longer (25) smoother but slower to react. Match the lookback to your holding horizon.
What is RSI divergence?
When price makes a new high but RSI makes a lower high (bearish divergence), or price makes a new low but RSI makes a higher low (bullish divergence). Often signals waning momentum before a price reversal.