RSI Indicator: Buy and Sell Signals

The Relative Strength Index (RSI) is one of the most widely used momentum indicators in technical analysis. It helps traders identify overbought and oversold conditions and generates potential buy and sell signals.

Developed by J. Welles Wilder Jr., the RSI measures the speed and magnitude of recent price changes. Traders often combine RSI with other indicators like the Moving Average Convergence Divergence (MACD), moving averages, and the average directional index (ADX) to refine their trading strategies and confirm trends.

How the RSI Indicator is Calculated

RSI is calculated by taking the average size of price gains on up days and declines on down days over a set period, with 14 being the default. The indicator oscillates between 0 and 100. The midpoint is 50.

$RSI = 100 - (100/1 + RS)$RSI=100−(100/1+RS)

where:

RS (Relative Strength) = average gain over a specified period/average loss over the same period

A value above 50 generally indicates bullish momentum, while a value below suggests bearish momentum. Traders use RSI in various ways, including identifying overbought and oversold conditions, confirming trends, and spotting possible reversals via divergences. They also use it with several other indicators, including moving averages and Bollinger Bands, to provide stronger signals.

History and Development

J. Welles Wilder Jr. introduced the RSI in his book "New Concepts in Technical Trading Systems", which was released in 1978. The tool quickly became a cornerstone of technical analysis, helping traders identify overbought and oversold conditions, trend exhaustion and potential reversals.

Initially calculated by hand for use in commodities and futures trading, the RSI was easily applied to stocks, currencies, and just about every other market with the rise of commercially available charting software. This solidified its position as a leading technical indicator for retail and institutional traders.

Traders' use of the RSI has evolved over time, including by adjusting timeframes and thresholds to improve accuracy for particular markets. Moreover, algorithmic trading and quantitative finance have incorporated RSI into automated strategies, with variations like Stochastic RSI enhancing its adaptability.

Interpreting RSI Values

Overbought and Oversold

In technical analysis, overbought and oversold conditions exist when an asset's price has made an extreme move in one direction, making it ripe for a mean reversion or correction. With the RSI, which oscillates between 0 and 100, 70 is considered the default overbought threshold and 30 the oversold threshold.

In addition, an RSI move above 50 warns of strengthening bullish momentum, reinforcing the potential for an upward trend. A drop below 50 suggests a shift toward bearish momentum, indicating potential further downside.

The RSI in Trending Markets

Many traders read the RSI differently in trending markets. In uptrends, RSI tends to stay between 40 and 70, with overbought conditions above 70 indicating strong momentum rather than an imminent reversal. Traders often looking for dip-buying opportunities when RSI pulls back to around 50 rather than waiting for it to drop below 30—something that rarely happens in strong uptrends.

Conversely, in downtrends, the RSI usually remains under 60, with oversold levels below 30 occurring more often. Instead of expecting an immediate rebound, many traders look for rallies toward 50 to 60 as potential selling opportunities, treating RSI as a dynamic resistance level.

Traders can refine their decision making by adjusting RSI thresholds based on market conditions, as RSI tends to stay higher in uptrends and lower in downtrends. This helps avoid premature selling or buying solely based on traditional RSI levels.

Trading With the RSI

Trading with the RSI isn't as simple as selling (or shorting) what's overbought and buying what's oversold. During a strong trend, an RSI reading can remain overbought or oversold for many days (or hours, or whatever your trading timeframe is), so at the very least one needs to be patient about when to enter a countertrend trade.

The trend also matters. If the move to overbought conditions is part of a dominant trend higher—rather than a countertrend move—then any reversal is likely to be relatively short-lived, since a strong, recent trend will likely retest its previous high before too long.

Making an Exit

RSI pullbacks from overbought and oversold levels can also signal to exit an existing trade. For example, if you've got a long position, a cross below the 70 reading is a solid sell signal for a short-term trader who doesn't want to sit through a likely pullback.

Divergence and Trend Reversals

One of the strongest RSI signals is divergence, whether bullish or bearish. Bearish divergence occurs when the RSI forms lower highs while price forms higher highs. Bullish divergence happens when the RSI forms higher lows while the price of the asset makes lower lows.

It's best to seek confirmation of the reversal before entering a countertrend move. In any case, divergence helps traders make better decisions rather than just relying on RSI levels.

Failure Swings

The failure swing is probably the strongest way to play a reversal using the RSI. It acts as confirmation of trend reversals and often appears with divergence, strengthening the case that a true turning point has been reached. Because failure swings require the RSI to break its own support and resistance levels, they add an extra layer of evidence that price is reversing direction.

Here's how traders typically play a bullish failure swing:

1. The RSI moves below 30
2. The RSI moves back above 30, forming a short-term peak
3. The RSI moves lower again, but remains above 30
4. The RSI moves above the high formed in step 2, confirming a reversal

Wilder regarded failure swings as strong standalone signals of trend changes, and they remain a valuable technique.

Range-Bound Trading With the RSI

The RSI is a great tool for mean reversion trading. Unlike with trending markets, when price is rangebound traders can buy near support when the RSI is below 30 and sell near resistance when it is above 70. To improve accuracy, traders should confirm price alignment with support or resistance and use tight stop-losses in case the range breaks.

Combining RSI with Other Indicators

Generally, technical analysis tools tend to complement each other. In particular, the RSI's effectiveness increases when combined with other indicators. Pairing RSI with the MACD helps confirm trend reversals as the two measure momentum differently.

For instance, an RSI oversold reading gains credibility when followed by a MACD bullish crossover. In a similar fashion, RSI overbought signals accompanied by a bearish crossover strengthen the case for a potential pullback.

Moving averages are another great tool to use with the RSI. Traders often focus on RSI buy signals in an uptrend and sell signals in a downtrend. This alignment with broader trends improves trade accuracy and reduces false signals.

Beyond trend indicators, traders also integrate RSI with Bollinger Bands, support and resistance levels, or volume analysis to enhance decision-making. An oversold RSI paired with price touching a lower Bollinger Band or a key support level adds confidence to a potential rebound. Likewise, an RSI breakout supported by high volume confirms strong market participation.

Overall, the RSI works best as part of a holistic strategy, not in isolation. By combining it with complementary indicators, traders improve their ability to filter out noise, make informed decisions, and increase the reliability of their trade setups.

The Bottom Line

RSI is one of the most popular technical analysis indicators, helping traders spot overbought and oversold conditions and pullbacks in a strong trend. However, it's most effective when combined with tools like the MACD, moving averages, and Bollinger Bands to minimize false signals. Rather than acting on the RSI alone, successful traders use it alongside other indicators and price action techniques to make better decisions.