RSI in Depth: Advanced Uses

In short: The RSI measures the momentum of the price on a scale of 0 to 100. This tutorial assumes you already know the basics and goes deeper into the calculation, use within a trend and divergence. The RSI lags the price and regularly gives false signals.

See also the practical example in RSI in Practice. This tutorial explains the theory.

How is the RSI calculated?

The RSI (relative strength index) compares the average gain with the average loss over a fixed period, usually 14 candles.

1. Calculate the average gain (rising candles only) and the average loss (falling candles only) over 14 periods.
2. Divide the average gain by the average loss. That is the relative strength (RS).
3. RSI = 100 − 100 ÷ (1 + RS).

An example: the average gain is €0.60 and the average loss €0.40. RS = 0.60 ÷ 0.40 = 1.5. RSI = 100 − 100 ÷ 2.5 = 60. Suppose the average gain is €1.20 and the loss €0.30: RS = 4 and RSI = 100 − 100 ÷ 5 = 80.

Most platforms use the version by J. Welles Wilder, the inventor of the RSI. It “smooths” the averages so that old prices slowly lose their influence. You do not have to calculate this yourself, but it helps to know that the RSI says nothing about the value of a stock. It only measures how fast the price moved.

Overbought and oversold

Rule of thumb: above 70 the market is “overbought”, below 30 “oversold”. These are conventions, not laws of nature. In a strong rise the RSI can stay above 70 for weeks while the price keeps climbing. Anyone who sells at 70 then misses part of the move. So treat 70 and 30 as points of attention, not as automatic buy or sell signals.

The RSI in a trend

A common approach is to read the RSI in light of the trend. As a rule of thumb:

• In an uptrend the RSI often stays roughly between 40 and 80. Dips towards the area around 40 to 50 are then seen by some as possible entry moments.
• In a downtrend the RSI often stays roughly between 20 and 60. Rises to 50 to 60 can then be a counter-move.

These are not fixed limits. They differ per stock, market and period. Check on a chart of your own market how the RSI behaved in earlier trends. See also Moving Averages for determining the trend.

The line at 50 is also used as a midline: an RSI above 50 points to more rising than falling momentum, below it the opposite.

Divergence

Divergence means the price and the RSI move apart.

• Bearish divergence: the price makes a higher high, but the RSI a lower high. The momentum of the rise is fading.
• Bullish divergence: the price makes a lower low, but the RSI a higher low. The momentum of the decline is fading.

Divergence is a warning, not a signal to trade straight away. The price can keep going for weeks while the divergence stays visible. Many traders therefore wait for confirmation, such as a break of a support level or a reversal pattern in a candlestick.

Worked example (hypothetical)

Suppose stock X makes a low of €30.00 with an RSI of 24. It then falls to €29.40, but the RSI only reaches 31 (a higher low). That is bullish divergence. The price then rises with a clear candle above €30.60 and you buy at €30.70.

• Stop-loss: €29.20 (below the latest low). Risk per share: €30.70 − €29.20 = €1.50.
• Price target at 2:1: €30.70 + 2 × €1.50 = €33.70.

It can also go differently: the price falls through €29.20 and your stop-loss limits the loss to €1.50 per share. Decide your position size with the position size calculator.

Limitations

• It lags: the RSI is calculated from earlier prices. It predicts nothing.
• False signals in strong trends: “oversold” can be a bottom, but also just a price that keeps falling.
• Divergence can last a long time: you can be far too early, or the signal never plays out.
• Setting and market: the default of 14 is a habit. A different period gives different signals. Do not optimise until it looks perfect on historical data (overfitting).
• Timeframe: an RSI on a 5-minute chart gives many more signals than on a daily chart, and more noise.
• Do not use alone: combine the RSI with trend, levels and a stop-loss. See also Combining Multiple Indicators.

Practice questions

Try to answer them yourself. The answers are in the text.

1. What does the RSI measure and what does it not measure?
2. Why is “RSI above 70” not a sell signal?
3. What is the difference between bullish and bearish divergence?
4. What is a disadvantage of a shorter RSI period?

What next?

Test on historical data how the RSI reacts on your market before you risk real money. Use a stop-loss and keep your risk per trade small.