RSI: overbought and oversold without myths

Imagine a barista making espresso at the pace of ten cups an hour, and then suddenly at thirty. You would not say at once that the coffee is too expensive or too cheap. You would say the pace is exceptional. RSI does exactly that for the market: it measures the pace of rises and falls, not their "fairness". That difference is the heart of this whole lesson.

What you will learn

• how RSI is built and what exactly it measures,
• what the 30, 50 and 70 levels really mean,
• how RSI behaves in a trend and why "overbought" is not a sell signal.

Where RSI comes from

The Relative Strength Index was introduced in 1978 by J. Welles Wilder. It asks one thing: over the last n sessions, were the rises bigger or the falls? The standard n is 14.

1. For each session you calculate the change of the close versus the previous one. Rises are U, falls (as positive values) are D.
2. You calculate the averages of U and D over 14 sessions; Wilder used his own smoothing, similar to an exponential average.
3. RS is the ratio of the average rise to the average fall.
4. RSI = 100 − 100 / (1 + RS)

The result always lies between 0 and 100. If everything rose over 14 sessions, RSI would approach 100; if everything fell, 0; when rises and falls balance, it hovers around 50.

The 30, 50 and 70 levels

Textbooks teach: above 70 the market is overbought, below 30 oversold. That is a simplification that has misled people for decades. The 30 and 70 levels are a convention, not a law of nature.

• RSI > 70 means only that recent rises were clearly bigger than falls. It describes strength, not a forecast of reversal.
• RSI < 30 means that recent falls clearly dominated.
• The 50 level is the border of advantage: above it rises prevailed, below it falls.

Much more important is how RSI behaves over time. In a strong uptrend RSI usually moves in a band of roughly 40–90 and rarely falls below 40: pullbacks end right around 40–50. In a strong downtrend the band shifts down, to roughly 10–60. So if in a rising trend RSI turns around at 40, it signals that the trend continues, not that it has ended.

The parameter

A length of 14 is tradition, not dogma. A shorter RSI (say 7) is more sensitive, enters extreme zones more often and gives more signals, but also more noise. A longer one (say 21) is calmer and reaches extremes less often. There is no "best" length: pick one and use it consistently.

Chart example: Palantir (PLTR), daily chart

Palantir is a stock whose shares have gone through violent rallies in recent years. In such phases RSI can sit in the overbought zone for months while price keeps rising. It is an ideal chart for seeing how costly mechanical "sell because RSI is above 70" can be.

Open the daily chart of PLTR for the last two years and add RSI(14). Mark all periods in which RSI exceeded 70 and check two things: how long they lasted and what price did in the 10 sessions after the first crossing. Then do the same for the level 30. The result will show you that what is "overbought" is often simply strong.

How it fails

• Overbought does not mean sell. In strong trends RSI stays in the extreme zone for a very long time. Selling at the first crossing of 70 means leaving the best moves.
• Oversold does not mean buy. A falling stock can have an RSI below 30 for weeks while its price keeps dropping.
• Sideways market. RSI works best in a consolidation, but even there it is not sacred: bounces from 30 and 70 make sense mainly when they coincide with a support or resistance level.
• No certainty. RSI is a function of price, not an independent source of information. It knows nothing the chart does not know.

Check yourself

1. How is RSI(14) calculated?
2. In what band does RSI usually move in a strong uptrend?
3. Is RSI above 70 a sell signal? Why?
4. How does changing the parameter from 14 to 7 affect the indicator?

Next lesson

Lesson 10. MACD: averages in a single oscillator: two averages, one line and a histogram that slows down before price does. It sounds like magic, but it is simple arithmetic. I will show you how to use it and in what kind of market MACD starts to lie.

Educational material, not investment advice.