The Relative Strength Index (RSI) is a popular momentum oscillator widely used by traders to identify overbought and oversold conditions in the market. Developed by J. Welles Wilder in 1978, the RSI helps traders gauge the speed and change of price movements, providing insights into potential trend reversals or continuations.

At its core, the RSI oscillates between 0 and 100. Traditionally, an RSI value above 70 suggests that an asset is overbought, meaning it might be due for a price correction or pullback. Conversely, an RSI below 30 indicates that an asset is oversold, suggesting a possible price rebound or upward reversal. However, these levels are not rigid rules but rather guidelines, and traders often adjust these thresholds depending on the asset or market conditions.

The formula used to calculate RSI is as follows:

Formula: RSI = 100 – (100 / (1 + RS))

Where RS (Relative Strength) = Average Gain over N periods / Average Loss over N periods.

Typically, the default period (N) is 14, meaning the RSI is calculated over the last 14 trading periods. Average gains and losses are smoothed using Wilder’s smoothing method, which is similar to an exponential moving average.

To illustrate, consider a trader analyzing the EUR/USD currency pair on a daily chart. Suppose over the past 14 days, the average gain was 0.0050 (or 50 pips) and the average loss was 0.0025 (25 pips). The RS would be 0.0050 / 0.0025 = 2. Using the formula:

RSI = 100 – (100 / (1 + 2)) = 100 – (100 / 3) ≈ 66.67

An RSI of approximately 67 indicates moderate strength, but not yet overbought. If the RSI were to climb above 70, the trader might start looking for signs that the EUR/USD could reverse or consolidate soon.

One real-life example involves the S&P 500 index during the early months of 2021. After a strong rally, the RSI climbed above 70 several times, signaling overbought conditions. Some traders used this as a cue to tighten stop losses or take partial profits, anticipating a pullback. Indeed, the index experienced short-term corrections, which validated the RSI’s role in highlighting potential overextension.

Despite its usefulness, the RSI is not without pitfalls. A common misconception is that RSI signals always lead to immediate reversals. In strong trending markets, the RSI can remain in overbought or oversold territory for extended periods. For example, in a powerful uptrend, the RSI might hover above 70, and selling solely based on this could cause traders to miss out on further gains. This phenomenon is often referred to as “RSI staying overbought” or “RSI stuck in overbought/oversold zone.”

Another frequent mistake is ignoring divergence signals. Divergence occurs when the price makes a new high or low, but the RSI does not confirm this move. Bullish divergence happens when prices hit a new low but RSI forms a higher low, suggesting weakening downside momentum. Bearish divergence is the opposite. Many traders overlook these subtle cues, missing valuable early warnings of trend changes.

People often ask related questions such as “What is a good RSI setting for day trading?”, “How to combine RSI with other indicators?”, or “Can RSI be used on all asset classes?” The answer is that while the default 14-period RSI is most common, shorter periods (like 7 or 9) can make the indicator more sensitive, which may suit day traders. Combining RSI with volume indicators, moving averages, or trend analysis can improve signal reliability. RSI works well across various assets—stocks, forex, commodities, and indices—but understanding the unique characteristics of each market is essential.

In conclusion, the Relative Strength Index remains a valuable tool for many traders. It provides a straightforward way to assess momentum and identify potential turning points. However, it’s important to use RSI in context, alongside other analysis methods, and avoid relying solely on its signals. Recognizing its limitations and common mistakes can help traders make more informed decisions and improve overall trading performance.