RSI (Relative Strength Index)
The Relative Strength Index is a measurement of the speed and magnitude of price movements. It was developed in 1978 by J. Wilder, a mechanical engineer and real-estate developer with an interest in the stock market who developed several foundational technical indicators. Since then, many different ways to use and interpret RSI have been developed, but his indicators have stood the test of time.
This simple indicator is what is called an oscillator, meaning it moves within a range. In the case of RSI, between zero and 100. You can think of it as a spring that can be compressed and expanded within certain limits. Without any external force, it will return to its natural state in the middle.
What RSI measures is a stock's momentum, meaning it looks at how fast a stock is moving and in what direction. This is similar to measuring the average acceleration of a car as it speeds up and slows down.
Combining momentum and direction together gives you a momentum oscillator that acts as a leading indicator, a measure that is designed to move before the price of a stock and indicate what will likely happen to that stock's price. This is similar to how someone's face may turn green before they get sick, letting you know that something is going to happen before it actually does.
The most common RSI signals are overbought and oversold, generally considered to be a level of 70 and 30, respectively. When the RSI exceeds 70 it means that the stock is likely overheating and is due for a pullback. When the RSI dips below 30 it indicates that the stock may be oversold and due for a rebound.
Divergences are less common than Overbought/Oversold signals, and arguably more reliable. When a divergence takes place, a few specific price and RSI movements must occur in tandem.
A bullish divergence begins with the stock price and RSI both having recent lows in a specific period before rebounding together. The stock must then fall again to a price lower than the first dip. If this occurs and the RSI remains higher than the previous low, you have a bullish divergence.
Similarly, a bearish divergence begins with the stock and RSI breaking recent highs before falling together. The stock must then rise again to a price higher than the first peak. If this occurs and the RSI remains lower than the previous high you have a bearish divergence.
This article should give you a better sense of how you can incorporate this indicator into your investment strategy. Technical indicators work best when utilized on a diversified portfolio of fundamentally sound investments. Check out our other lessons on how to analyze an investment and construct a well-rounded portfolio.