The Relative Strength Index (RSI) was developed by J. Welles Wilder Jr. to measure asset momentum using price changes and the speed of those changes. Like stochastics, the RSI is an oscillator that reads between 0 and 100; in this case, the RSI calculation determines the ratio of upward and downward movement using 14 periods of data, then smooths it out so only strong trends approach 0 or 100. Traders traditionally interpret RSI values of 70 or greater as an indicator of an overbought asset, while values 30 or below indicate an asset has been oversold; higher or lower values (like 80 and 20) can be used to minimize the number of bought or sold readings.
Similar to stochastics, RSI may also display extended stretches of overbought or oversold behavior during stronger trends. Traders should not mistake the mere appearance of these indicators as signs of an imminent reversal of trajectory.
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While RSI and the stochastic oscillator share numerous similarities (and are often used side-by-side for analysis), they maintain some key differences. A foundational assumption of stochastics is that an asset’s closing prices generally reflect the direction of its overall trend; the RSI is more concerned with the rate of price movements. This means the RSI is best used for measuring the speed at which a price moves, and typically is more valuable in trending markets. Stochastics function best in up-and-down markets because they are most effective in consistent trading ranges.
Divergences on RSI can be a useful trading signal. Bullish divergences occur when an RSI indicates a higher low as security price reaches a lower low; a bearish divergence takes place when RSI shows a lower high as a security’s price trends higher. RSI divergences are not always true signals, however – assets can remain in trends for extended periods before reaching actual top or bottom.
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