Relative Strength Index (RSI)
A momentum oscillator that measures overbought and oversold conditions.
The relative strength index (RSI) is a momentum oscillator that measures the speed and magnitude of recent price changes on a scale from 0 to 100. Developed by J. Welles Wilder in 1978, it compares the average gain to the average loss over a specified period (typically 14 days). An RSI above 70 suggests the stock may be overbought. An RSI below 30 suggests it may be oversold.
Why It Matters
RSI helps options traders time entries and choose appropriate strategies. When RSI reaches extreme levels, it signals that the current move may be exhausted and due for a pause or reversal. An overbought stock with RSI above 70 is a poor candidate for buying calls at the top — it may be better suited for selling call spreads or waiting for a pullback. An oversold stock with RSI below 30 may present an opportunity for buying calls or selling put spreads into the weakness.
RSI is also valuable for confirming trends. In a strong uptrend, RSI tends to oscillate between 40 and 80. In a downtrend, it stays between 20 and 60. Understanding which range RSI occupies tells you the broader trend context before placing a trade.
How It Works
Calculation:
- Calculate average gain and average loss over 14 periods.
- RS (Relative Strength) = Average Gain / Average Loss.
- RSI = 100 - (100 / (1 + RS)).
Key levels:
- Above 70: Overbought — momentum may be fading, consider bearish or neutral strategies
- Below 30: Oversold — selling pressure may be exhausted, consider bullish strategies
- 50 level: The midpoint acts as a trend filter. RSI above 50 favors bullish bias; below 50 favors bearish
RSI divergence:
- Bullish divergence: Price makes a lower low but RSI makes a higher low. This suggests selling pressure is weakening and a reversal may be near.
- Bearish divergence: Price makes a higher high but RSI makes a lower high. Buying momentum is fading despite new highs.
Common mistakes:
- Assuming overbought means "sell immediately." In strong trends, RSI can remain above 70 for weeks. Overbought is not the same as bearish.
- Using RSI alone. It is best combined with price action, volume, or other indicators for confirmation.
Quick Example
A stock drops from $120 to $95 over two weeks and RSI hits 25 — deeply oversold. You see the stock holding a major support level at $95 and RSI begins curling up. You sell a put credit spread with the short put at $90, collecting premium while betting the oversold condition resolves with at least a stabilization. RSI climbs back above 30 within days, the stock bounces to $100, and your spread expires worthless for a full profit.