Momentum Oscillator

RSI (Relative Strength Index)

A momentum oscillator that measures the speed and magnitude of price changes to identify overbought and oversold conditions.

Overview

The Relative Strength Index (RSI) was developed by J. Welles Wilder Jr. in 1978. It oscillates between 0 and 100 and is typically plotted below the price chart.

Overbought Zone: RSI > 70 — Price may be overextended upward
Neutral Zone: RSI 30-70 — Normal trading range
Oversold Zone: RSI < 30 — Price may be overextended downward

Key Insight: RSI measures momentum. High RSI means recent gains are larger than recent losses. Low RSI means recent losses are larger than recent gains.

Mathematical Formula

Step 1: Calculate Average Gain and Average Loss

Average Gain = Sum of Gains over 14 periods / 14
Average Loss = Sum of Losses over 14 periods / 14

For subsequent calculations, Wilder uses a smoothing method similar to an exponential moving average.

Step 2: Calculate Relative Strength (RS)

RS = Average Gain / Average Loss

Step 3: Calculate RSI

RSI = 100 - [100 / (1 + RS)]

This formula normalizes RS to a 0-100 scale.

Smoothed Average Formula (after initial 14 periods)

Average Gain = [(Previous Avg Gain × 13) + Current Gain] / 14
Average Loss = [(Previous Avg Loss × 13) + Current Loss] / 14

Practical Example: MSFT Stock

14-day price changes for Microsoft

Gains (days price went up):

+2.50, +1.20, +3.10, +0.80, +1.50, +2.00, +0.60 = 11.70 total gain

Losses (days price went down):

-1.50, -0.90, -2.20, -1.10, -0.70, -1.30, -0.80 = 8.50 total loss

Step 1: Calculate Averages

Average Gain = 11.70 / 14 = 0.836
Average Loss = 8.50 / 14 = 0.607

Step 2: Calculate RS

RS = 0.836 / 0.607 = 1.377

Step 3: Calculate RSI

RSI = 100 - [100 / (1 + 1.377)]
RSI = 100 - 42.06 = 57.94

RSI of 57.94 indicates neutral to slightly bullish momentum

Parameters Explained

Period Setting (Default: 14)

The number of periods used to calculate RSI. Wilder originally used 14 days.

  • Shorter (9-13): More sensitive, more signals, more false positives
  • Standard (14): Balanced, Wilder's original recommendation
  • Longer (20-25): Smoother, fewer signals, more reliable in trending markets

Overbought/Oversold Levels

Traditional Levels (70/30)

RSI > 70 = overbought, RSI < 30 = oversold. Works well in ranging markets.

Adjusted for Strong Trends (80/20)

In strong uptrends, use 80/40. In strong downtrends, use 60/20. Reduces false signals.

Custom Levels

Some traders use 75/25 or 85/15 for less frequent signals with higher conviction.

Trading Signals

1. Oversold Bounce (RSI < 30)

Setup: RSI drops below 30 (oversold territory)

Entry: Buy when RSI crosses back above 30, confirming momentum shift

Exit: When RSI reaches 70 or crosses back below 30

Best for: Ranging markets, short-term reversals

2. Overbought Pullback (RSI > 70)

Setup: RSI rises above 70 (overbought territory)

Entry: Sell when RSI crosses back below 70

Exit: When RSI reaches 30 or crosses back above 70

Best for: Ranging markets, momentum exhaustion

3. Bullish Divergence

Setup: Price makes lower lows, but RSI makes higher lows

Interpretation: Selling pressure weakening despite lower prices

Entry: When RSI crosses above 30 or price breaks above recent resistance

Best for: Catching trend reversals at market bottoms

4. Bearish Divergence

Setup: Price makes higher highs, but RSI makes lower highs

Interpretation: Buying pressure weakening despite higher prices

Entry: When RSI crosses below 70 or price breaks below recent support

Best for: Catching trend reversals at market tops

5. Centerline Crossover (50 Level)

RSI > 50: Bullish momentum — average gains exceeding average losses

RSI < 50: Bearish momentum — average losses exceeding average gains

Crossing 50 can signal trend changes or continuation

6. Failure Swings

Bullish Failure Swing

RSI drops below 30, rallies, pulls back but stays above 30, then breaks previous high — strong buy signal

Bearish Failure Swing

RSI rises above 70, pulls back, rallies but stays below 70, then breaks previous low — strong sell signal

Common Mistakes

Selling Just Because RSI is Overbought

Problem: In strong uptrends, RSI can stay overbought (>70) for weeks. Selling early misses major gains

Solution: In trending markets, use overbought/oversold as confirmation, not signals. Wait for trend break

Using Same Levels in All Market Conditions

Problem: Traditional 70/30 levels generate too many false signals in trending markets

Solution: Adjust levels based on trend strength: use 80/40 in uptrends, 60/20 in downtrends

Ignoring Price Action

Problem: RSI divergence doesn't guarantee reversal without price confirmation

Solution: Wait for support/resistance breaks or candlestick patterns to confirm RSI signals

Trading Every Divergence

Problem: Not all divergences lead to reversals, especially small divergences

Solution: Look for multiple touches (2-3 points) and significant divergence. Confirm with volume

Best Practices

Market Context

Trending Markets

Use RSI for divergence and momentum confirmation, not reversals

Ranging Markets

Trade overbought/oversold levels with tight stops

Timeframe Analysis

  • • Check RSI on higher timeframe first
  • • Daily RSI for swing trading
  • • 4H/1H RSI for day trading
  • • Signals align = stronger probability

Confirmation Indicators

  • • Volume spikes on reversal signals
  • • Support/resistance confluence
  • • Candlestick patterns (engulfing, doji)
  • • MACD or moving average confirmation

Risk Management

  • • Stop loss below swing low (longs)
  • • Stop loss above swing high (shorts)
  • • Exit on RSI crossing back
  • • Position size based on volatility

Advanced Techniques

Hidden Divergence

Bullish Hidden Divergence

Price makes higher lows, RSI makes lower lows — trend continuation signal in uptrends

Bearish Hidden Divergence

Price makes lower highs, RSI makes higher highs — trend continuation signal in downtrends

RSI Trendlines

Draw trendlines on RSI itself (not just price):

  • • RSI breaking its own trendline can signal trend change before price
  • • RSI support/resistance levels can predict price reversals
  • • Useful for early warning of momentum shifts

Multiple RSI Periods

Use two RSI indicators with different periods:

  • • Fast RSI (5-9): For short-term momentum
  • • Slow RSI (14-21): For longer-term trend
  • • When both align = higher probability trades

Summary

RSI is one of the most popular momentum indicators in technical analysis. It works best when:

  • • Used in context of overall trend (don't fight the trend)
  • • Overbought/oversold levels are adjusted for market conditions
  • • Divergence signals are confirmed by price action breaks
  • • Combined with support/resistance and volume analysis
  • • Multiple timeframes show alignment

Remember: RSI > 70 in an uptrend can mean "strong momentum" not "time to sell." Context is everything. Start with the standard 14-period and 70/30 levels, then adjust based on the asset's behavior and market conditions.