Overbought or Oversold? Use the Relative Strength Index to Find Out

Relative Strength Index (RSI) is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset. The RSI is displayed as an oscillator (a line graph that moves between two extremes). It can have a reading from 0 to 100. The indicator was originally developed by J. Welles Wilder Jr. and introduced in his seminal 1978 book, New Concepts in Technical Trading Systems.

The primary trend of the stock or asset is an important tool in making sure the indicator's readings are properly understood. For example, well-known market technician Constance Brown, CMT, has promoted the idea that an oversold reading on the RSI in an uptrend is likely much higher than 30%, and an overbought reading on the RSI during a downtrend is much lower than the 70% level.

Traditional interpretation and usage of the RSI is that values of 70 or above indicate that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.

In terms of market analysis and trading signals, RSI moving above the horizontal 30 reference level is viewed as a bullish indicator, while the RSI moving below the horizontal 70 reference level is seen to be a bearish indicator. Since some assets are more volatile and move quicker than others, 80 and 20 are also frequently used overbought and oversold levels. 

Momentum and the Relative Strength Index

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During an uptrend, RSI tends to stay between different levels than during a downtrend. This makes sense, because the RSI is measuring gains versus losses. In an uptrend, there will be more gains, keeping the RSI at higher levels. In a downtrend, the RSI will tend to stay at lower levels.

During an uptrend, the RSI tends to stay above 30 and should hit 70 often. During a downtrend, it is rare to see the RSI above 70, and the indicator frequently hits 30 or below. These guidelines can aid in determining trend strength and spotting potential reversals. For example, if the RSI isn't able to reach 70 on a number of price swings in a row during an uptrend, and then drops below 30, the trend has weakened and could be reversing lower. 

The reverse is true for a downtrend. If the downtrend is unable to reach 30 or below, and then rallies above 70, that downtrend has weakened and could be reversing to the upside.

Trendlines

Like RSI, Moving Average Convergence Divergence (MACD) is another trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. The MACD is calculated by subtracting the 26-period Exponential Moving Average (EMA) from the 12-period EMA. The result of that calculation is the MACD line. A nine-day EMA of the MACD, called the "signal line," is then plotted on top of the MACD line, which can function as a trigger for buy and sell signals. Traders may buy the security when the MACD crosses above its signal line and sell, or short, the security when the MACD crosses below the signal line.

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