What is the RSI indicator?

How RSI is Calculated RSI is built from the average gain and average loss over a chosen period. The formula is: RSI = 100 – (100 / (1 + RS)) where RS = Average Gain / Average Loss over the period.

For the initial calculation, the average gain and loss are simple averages of the 14 periods. After that, Wilder used a smoothing method to avoid sudden jumps: Average Gain = [(Previous Average Gain × 13) + Current Gain] / 14 Average Loss = [(Previous Average Loss × 13) + Current Loss] / 14 If there is no gain, the gain is zero; if no loss, the loss is zero. This smoothing makes RSI less erratic than a simple moving average of RS.

Interpreting RSI Values The classic thresholds are 70 and 30, but these are not rigid. In strong uptrends, RSI can stay above 70 for extended periods without a reversal. In downtrends, it can hover below 30. Some traders adjust levels to 80/20 for volatile assets like cryptocurrencies or to 60/40 in ranging markets. The key is context: overbought does not mean “sell immediately”; it indicates that upward momentum is extreme and a pullback or consolidation may be near. Oversold suggests the opposite.

Common RSI Signals

1. Overbought and Oversold Crosses When RSI moves above 70 and then crosses back below, it can signal a potential short-term top. Conversely, crossing above 30 from below may hint at a bounce. However, these signals alone are prone to whipsaws in trending markets.

2. Divergence Divergence occurs when price and RSI move in opposite directions. Bullish divergence: price makes a lower low, but RSI makes a higher low. This suggests weakening downside momentum and a possible reversal upward. Bearish divergence: price makes a higher high, but RSI makes a lower high, warning of fading upside momentum. Divergence is more reliable when it appears at overbought/oversold extremes and is confirmed by price breaking a trendline.

3. Failure Swings Wilder described failure swings as strong reversal signals. A bearish failure swing: RSI rises above 70, pulls back, fails to exceed the prior peak on the next rally, and then breaks below the recent trough. A bullish failure swing is the mirror image below 30. These are less common but can provide high-probability setups.

4. Centerline Crossover The 50 level acts as a momentum barometer. RSI above 50 indicates average gains outweigh losses, favoring bullish momentum. A move from below 50 to above can confirm an uptrend, while a drop below 50 suggests bearish momentum. Many traders use 50 as a trend filter: only take long signals when RSI > 50, and short signals when RSI < 50.

Worked Example: 14-Period RSI Calculation Consider a stock with the following daily closing prices over 15 days (Day 0 to Day 14). We need 14 price changes to compute the initial RSI.

Day 0: $50 Day 1: $51 (gain 1) Day 2: $52 (gain 1) Day 3: $51 (loss 1) Day 4: $50 (loss 1) Day 5: $51 (gain 1) Day 6: $53 (gain 2) Day 7: $54 (gain 1) Day 8: $53 (loss 1) Day 9: $55 (gain 2) Day 10: $56 (gain 1) Day 11: $55 (loss 1) Day 12: $57 (gain 2) Day 13: $58 (gain 1) Day 14: $57 (loss 1)

Now, separate gains and losses for the 14 periods (Day 1 to Day 14): Gains: 1, 1, 0, 0, 1, 2, 1, 0, 2, 1, 0, 2, 1, 0 (losses are 0 for gain calculation) Losses: 0, 0, 1, 1, 0, 0, 0, 1, 0, 0, 1, 0, 0, 1

Total Gain = 1+1+0+0+1+2+1+0+2+1+0+2+1+0 = 12 Total Loss = 0+0+1+1+0+0+0+1+0+0+1+0+0+1 = 5

Average Gain = 12 / 14 ≈ 0.857 Average Loss = 5 / 14 ≈ 0.357

RS = 0.857 / 0.357 ≈ 2.40 RSI = 100 – (100 / (1 + 2.40)) = 100 – (100 / 3.40) ≈ 100 – 29.41 = 70.59

So the 14-day RSI is about 70.6, just into overbought territory. If the next day’s price rises to $58 (gain 1), the smoothed averages update: Previous Average Gain = 0.857, Current Gain = 1 New Average Gain = (0.857 × 13 + 1) / 14 = (11.141 + 1) / 14 = 12.141 / 14 ≈ 0.867 Previous Average Loss = 0.357, Current Loss = 0 (since it’s a gain) New Average Loss = (0.357 × 13 + 0) / 14 = 4.641 / 14 ≈ 0.332 RS = 0.867 / 0.332 ≈ 2.61 RSI = 100 – (100 / (1 + 2.61)) = 100 – (100 / 3.61) ≈ 100 – 27.70 = 72.30

This shows how RSI can climb further even when already overbought. The example illustrates why overbought alone is not a sell signal.

Limitations and Risk Context RSI can generate false signals in strong trending markets. During a powerful uptrend, RSI may stay overbought for weeks, and shorting based on that could lead to large losses. Similarly, in a crash, oversold readings can persist. Divergence can also fail: price may continue trending while RSI diverges for a long time before any reversal. Always use RSI with other tools like moving averages, volume, or trendlines.

Leverage, CFDs, and crypto trading amplify these risks. A false RSI signal on a leveraged position can wipe out capital quickly. Never rely on RSI alone for entry or exit. Implement strict risk management: define stop-loss levels, position size based on account risk (e.g., 1-2% per trade), and avoid overconfidence in any single indicator. Past performance does not guarantee future results.

Practical Checklist for Using RSI

• Identify the overall trend first (using a 200-period moving average or price structure).

• Use RSI to spot potential turning points within that trend.

• Look for divergence at overbought/oversold levels for higher-probability reversals.

• Confirm with price action: wait for a candlestick reversal pattern or a break of a short-term trendline.

• In ranging markets, overbought/oversold crosses can be more reliable; in trends, use RSI pullbacks to 50 or trendline breaks.

• Adjust the period: shorter periods (e.g., 7) increase sensitivity; longer periods (e.g., 21) smooth signals.

• Always set a stop-loss and take-profit based on market structure, not just RSI levels.

• Backtest any RSI strategy on historical data before using real money.