What is RSI in Stocks?

Where there’s money to be made, there are mathematicians trying to figure out how.

This is especially true for the stock market.

But – the best part? Us non-mathematicians can benefit from their hard work. ✅

Understanding the best ways to track the markets is essential for traders looking to make money. After all, some good trades and good luck can fund your next much-needed vacation or even early retirement. And it’s especially important to stay on top of the market when we’re on course for record-high stock valuations.

That’s where RSI comes in—it’s a favorite price prediction tool for many stock traders. RSI can be challenging to understand, but we’ve cut the math and concepts down to the essentials to get you started right away.

In this article, we will not only go through how this indicator works in theory, but also how reliable it is realistically (using real examples), and how it can be used effectively.

Ready? Let’s dive in! 🤿

What you’ll learn

• Understanding Stock RSI
• Basics of Calculating RSI
• What RSI Can Tell You
• Using the RSI Indicator When Trading
• RSI Divergence Patterns
• RSI Swing Rejection
• RSI vs. MCAD
• Pros and Cons
• 4 Tips for RSI Trading
• Conclusion
• What is RSI: FAQs
• Get Started with a Stock Broker

Understanding Stock RSI 🔎

In 1978 J. Welles Wilder published the book New Concepts in Technical Trading Systems. While the book might not sound like the most interesting read, it’s the first place Wilder described one very useful trading mechanism: the relative strength index. 

Simply put, RSI is a way that traders can analyze whether a security is overbought or oversold. It works by charting the velocity and momentum of price movement from the past 14 market days. If that doesn’t sound interesting yet, what might appeal to you is that the ultimate goal was to make more profitable trades, hopefully, keeping you ahead of 20% inflation. 🤞

Traders use RSI to understand the trends of a security or currency. While there is a bit of complicated math involved in uncovering all of what RSI entails, learning about the basics can give you a necessary edge to stay in the money. It can make you a better trader, and help you more fully understand what the market is doing.

How RSI Works 🏗

RSI is one of the indicators that traders use to analyze market activity. RSI is typically charted on a graph and oscillates between 0 and 100. The changes in the indicator are brought on by movement in the last close price of a security compared against previous periods. 

The change takes into account both momentum and velocity, meaning that large jumps in stock price will be reflected with greater movements of the indicator. In New Concepts in Technical Trading Systems, Wilder suggested that a 14-day period would be sufficient for plotting reliable trends.

Unless there is a diverging trend, RSI will often align with the ever-changing price of stocks. When the graph drops below 30, the asset is being oversold, when it peaks above 70, the asset is overbought. Typically, the line will return to the 30-70 range, which is considered neutral ground. Anything around 50 means that there is no discernable trend.

The RSI chart is located beneath the price chart. Looking at the price movement for Apple from July to October 2020, we can see how closely the price of the stock relates to RSI. According to RSI, the asset was overbought in late August and early September, which led to a sizable selloff in September. 

From March to June, the price movements were less extreme in volume and momentum, consequently, RSI stayed more neutral. This might be a reason some investors are losing interest in the tech giant.

If we look at more speculative security from a similar period, the RSI will reflect more extreme trends. During January 2021, the RSI reached nearly 100— this is an extreme sign that the asset is overbought, and a return to more neutral activity is inevitable. 

Of course, Gamestop was dealing with some extreme media coverage during this time and was even the focus of SEC hearings. Investors need to be aware of the broader context surrounding a stock to adjust their understanding of its activity.

Basics of Calculating RSI ➗

Let’s break down the math behind RSI, stay with us here, we’ll try to keep this as painless and short as possible. Besides, figuring out how the metric works will help you understand what’s going on behind the graph.

Upward movement U is calculated by subtracting the previous close price from the current close price. Inversely, any downward movement D comes from subtracting the current close price from the previous close price. Pretty easy, right?

The upward and downward movements are averaged using a smoothed moving average (SMMA) against a defined period of n, which is typically 14 days. If we divide the smoothed upward movement by the smoothed downward movement for a set period, we get the relative strength of the stock RS.

Using the Relative Strength figure, we can now normalize the value to get a figure between 1 and 100 using the formula below. This is the number plotted to our chart.

Of course, to use the RSI in trading you don’t need to know this formula—you can just use an indicator on your charting software. Nonetheless, if you ever wondered how RSI works, this is how.

What RSI Can Tell You 💡

The primary reason that technical traders use RSI is that it provides data about bearish and bullish movements. These insights, along with analysis of charts, help increase the odds of making profitable trades

Although RSI gives insight into trends, it’s important that traders still look at these trends in the context of the market, the overall bearish or bullish activity of the stock, and other technical indicators. This is especially true when confronted with increased distrust in the market and high inflation.

While 30 and 70 are normally the key lines for oversold and overbought assets, the levels can change depending on the security you’re trading. Sometimes the high point of an asset will be around the 50 mark, and can sometimes even be lower. The oversold trends may even be greater than 30 depending on conditions.

Oftentimes, traders will need to use RSI in tandem with other techniques to verify trends. It is important to do technical analysis to find triggers for purchases. While RSI is important, these other methods will give confirmation, meaning the trades are more insured against loss.

How to Use the RSI Indicator in Stock Trading 📈

When it comes to stock trading RSI is an incredibly useful technical indicator. It can help you predict where the market is moving. All it takes is developing your understanding of various patterns that emerge as you evaluate the RSI chart.

For the most part, you will want to pair your knowledge of RSI with other indicators so that you aren’t banking too much on price movement alone. If you are interested in knowing about the long-term investment potential of a company, you may want to avoid RSI altogether, and instead, look into fundamental analysis. 

RSI can help you turn a profit in the short term, the prospects of this are less certain over longer periods. This is why some traders prefer to simply put their money in the S&P 500. The trends you find will help you get in and out of trades within the same day, or over a period of a few days.

The changes can happen quickly, so it will require you to pay close attention to the market. The best way to learn these trends comes from practicing with paper trading before rolling it out with any of the top brokers specifically for day trading.

RSI Divergence Patterns 📊

RSI can be used in stock trading to find cues for opening trade orders—but sometimes the indicators fall apart. When RSI or other technical indicators fail, you are witnessing a divergent pattern. 

We’ve seen investors take advantage of this kind of volatility with even the largest companies, and so it can work with your stocks too. The market is rejecting what the indicators are telling investors, meaning that the current trend is receding and you better have your stop-loss orders set.

A bearish indication happens when the relative strength index shows an overbought condition, but then there is a lower high than the recent peak high. This means that the bullish trend is reversing.

Conversely, when a bullish divergence happens, RSI will indicate that an asset is oversold, then there will be a higher low than the previous lows in the market. This means that bullish movement is on the rise and it’s time to switch your short position into a long one.

Divergence patterns are key to understanding RSI. They will only work in the current market context, but understanding when the current conditions are changing gives traders the advantage they need to keep themselves in the money.

RSI Swing Rejection 👇

Swing rejection occurs when the market is normalizing after reaching overbought or oversold conditions. This gives traders an opportunity to capitalize on the tendency for the market to normalize.

There are two kinds of swing rejection for each area on the RSI chart. One comes when oversold conditions have been met, the other is from overbought conditions. Both methods rely on a rejection of the current trend.

Overbought Swing Rejection ✔️

The overbought swing rejection will occur when the market is heading for a downtrend. The RSI will first show indications that the asset is overbought. It will then dip below the 70 overbought line (or other marker depending on your analysis) once it drops below the 70 line, it will peak again, but will not reach the same high or even cross the previous marker. 

Then the RSI will fall downwards, below its most recent low. It’s advantageous to be short on bearish trends like this. This means you can capitalize on the recent highs while betting against the asset.

Oversold Swing Rejection ✔️

The oversold swing rejection mirrors what the overbought rejection shows. The RSI will dip below the 30 line (or whatever metric you are using to analyze given market conditions) it will then rise above 30, and crash back below, but will not reach the 30 mark again. 

Then the asset will be in for a bullish rise. When an oversold swing rejection occurs, it is advantageous to have long positions that can be closed before the asset falls back into oversold territory.

RSI vs. MCAD ⚖️

As you know, RSI measures whether an asset is overbought or oversold. On the other hand, Moving Average Convergence Divergence, or for those who prefer less of a mouthful, MCAD, measures the difference between two 26-period exponential moving averages. It may sound a little complicated, but basically, MCAD is a way to generate buy and sell signals using two different statistical averages compared against each other.

While RSI and MCAD are both important indicators for investors to generate signals for entering and exiting trades, they can sometimes give contradictory information. This is because they draw their data from different places. RSI looks at price movement and overall momentum, while MCAD is looking at moving averages.

Relative Strength Index Pros and Cons 👍👎

Benefits of RSI ✅

The main benefit of RSI is that it gives indications of when a market is overbought or oversold. This is critical for avoiding reversals and losing out on your investment. It’s especially useful in short-term investing where traders can take advantage of quick price changes. These are especially effective when there are large leaps in the stock markets and cryptocurrencies.

The major benefit of RSI is that it gives information on these signals when a market can change. It leverages previous trades and the overall volume of an asset to give an overview of the stock without looking entirely at the price alone.

Drawbacks of Using RSI ⚠️

The biggest drawback of using RSI comes from its inability to be confirmed without using outside metrics. Traders need to have their trends confirmed with other resources to get a full understanding of the market.

In addition to this shortcoming, traders also need to adjust their understanding of the overbought and oversold points depending on market conditions and even our frightening economic situation. For new users, this can be a challenge. It isn’t always clear when there is an emerging trend, a reversal, or a divergence.

Even for people who have done extensive analysis with RSI, it can be difficult to tell when a reversal will happen after reaching overbought or oversold territory. While assets will tend to normalize after hitting either extreme, the reversals may come very slowly. The signals may stay active for days or even weeks.

4 Tips for RSI Trading 🎯

When using RSI there are a couple of tips to keep in mind. You will need to adapt your method depending on your particular trading strategy. 

1. Adjust Your Timetable 📅

Depending on your trading style, you may need a tighter or longer time range to analyze the markets. While the developer of RSI suggested 14 days to get the best information, you can extend that or shorten it to fit your methods.

2. Don’t Rely Solely on RSI ⚠️

You can’t make all of your trading decisions using RSI. You need to look at other indicators and the overall price movement before you purchase. If you are new to investing, you should understand the basics of trading before jumping into complex analysis.

3. 30 and 70 Are Not Absolutes 🔓

If it doesn’t look like trends are emerging below 30 and past 70, you may need to tune your range for signals. Not every asset is going to be the same. Making adjustments can help you find the right values for finding signals.

4. Learn Divergence 🎓

Keep an eye out for when RSI doesn’t match up with the price movement of an asset. This is key for finding the divergence and changing your orders to keep your profits intact.

The Bottom Line 🏁

Knowing how to read trends is important, but so is knowing how to confirm the data you are looking at against other technical indicators. While RSI is one of the most popular oscillator indexes out there, it isn’t without its flaws. Relying on RSI and your other indicators will help keep emotions out of your trades and keep you making a profit when others are panicking. 

You’ve made it all the way through our guide on RSI and now you are a pro at recognizing divergence and swing rejections! You’re ready to get out there and start making trades with another complicated acronym to fit into your trading tool belt. 🎉🎉🎉

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Fees

Minimum initial deposit

TS Select: $2,000

TS GO: $0

$0

$0

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$0

Vary

$0

Account minimum

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General

Best for

Active options and penny stock trading

Active traders

DIY stock trading

Highlight

Powerful tools for professionals

Huge discounts for high-volume trading

Pioneer of commission-free stock trading

Promotion

50% Off Future

Free stock

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About the author

Tim Fries

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Tim Fries is the cofounder of The Tokenist. He has a B. Sc. in Mechanical Engineering from the University of Michigan, and an MBA from the University of Chicago Booth School of Business. Tim served as a Senior Associate on the investment team at RW Baird's US Private Equity division, and is also the co-founder of Protective Technologies Capital, an investment firm specializing in sensing, protection and control solutions.