What the RSI Measures and How It Works
RSI compares the average gain on up days to the average loss on down days over a set lookback period, typically 14 days. The formula produces a value from 0 to 100, where 50 represents a balance between buying and selling pressure. RSI does not measure the direction of price movement, only the speed and magnitude of recent changes. A rising stock can have a declining RSI if it is slowing down, and a falling stock can have a rising RSI if the selling is slowing. The indicator isolates momentum separate from price, making it useful for spotting divergences.
Overbought and Oversold Signals
RSI above 70 is considered overbought, suggesting a stock has moved up rapidly and may be due for a pullback or reversal. RSI below 30 is considered oversold, suggesting a stock has fallen quickly and may bounce. Traders often buy oversold stocks expecting recovery and sell overbought stocks expecting pullback. However, these thresholds are not hard rules - strong uptrends can see RSI remain above 70 for weeks, and downtrends can keep RSI below 30 indefinitely. The best way to use overbought and oversold levels is to watch for reversal patterns or divergences rather than treating them as automatic entry and exit signals.
Divergences and Hidden Signals
A bullish divergence occurs when price makes a new low but RSI does not, suggesting selling momentum is weakening even though price is falling. A bearish divergence occurs when price makes a new high but RSI does not, hinting that upside momentum is fading. These divergences often precede reversals and are considered one of the most reliable RSI signals. Divergences work best on longer timeframes like daily and weekly charts because they give more time for reversals to play out. On intraday timeframes, divergences appear frequently but are less reliable due to noise and false signals.
Limitations and When RSI Fails
RSI is a lagging indicator because it relies on historical price data - by the time it shows overbought or oversold conditions, much of the move has already happened. It works poorly in ranging markets where price oscillates sideways, generating constant false signals. In strong trending markets, RSI stays overbought or oversold for extended periods without predicting reversals. RSI also ignores volume, news events, and fundamental catalysts that matter to price. It is best used in combination with price action, support and resistance levels, and other indicators rather than as a standalone signal.