What Is RSI in the Stock Market?

In the stock market and other financial markets, "RSI" refers to the relative strength index, an important technical indicator in trading stocks, bonds, commodities, futures, options and currencies. It tells you approximately how much your security is overbought or oversold in the market. It was developed by J. Welles Wilder as an oscillator that combines the average gain and average price loss of a security over a specified period.

Overbought

Price movement in a security, such as stock, is based on supply and demand. If there are more buyers than sellers, the price rises. Sometimes good news about a company will attract an unusual amount of buying interest in its stock, driving the price higher. The term "overbought" refers to the point at which the orders to buy, versus the amount of stock for sale, are far out of balance. At some point in the stock's price rise, investors who owned the stock before the news announcement will decide to take their profits. The RSI for that stock attempts to show when that point is about to be reached.

Oversold

When there are more sellers of a stock than buyers, that stock's price will fall. The term "oversold" refers to the point at which selling interest has far outpaced the normal balance of the marketplace. During a stock's price drop, there is a point at which some investors see value, and they start buying the stock. The RSI attempts to show when that point is likely to occur.

Uses

When a stock is rising in price, its RSI will also rise. The RSI scale is from 1 to 100, with 1 being the maximum of oversold and 100 being the maximum of overbought. In technical analysis, when RSI reaches 30 it is time to consider buying, and when it reaches 70 it is time to consider selling.

Divergences

Sometimes the RSI of a stock declines to below 30 or rises above 70 but the price of the stock starts moving in the opposite direction. This is called a divergence. If the price of a stock turns up or flattens with an RSI below 30, it is considered a buy signal. Similarly, if the RSI continues to rise above 70 and the stock price flattens or starts to decline, it is thought to be an indicator that buying interest has significantly diminished and a sell-off is approaching.

Considerations

No technical indicator is foolproof. Experienced market technicians use several indicators, along with price charts, to make their buy and sell decisions. With RSI, there is always the possibility that a stock might extend its overbought or oversold condition, particularly if the stock is considered a hot buy or a declining credit.

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