The RSI (Relative Strength Index) is a technical indicator developed by J. Welles Wilder to measure the speed and amplitude of price changes, i.e. momentum, over a defined period (usually 14 days). On a chart, it appears as a curve oscillating between 0 and 100.
When it exceeds 70, the asset is often considered to be overbought. This means that there is a risk, but not a certainty, of a bearish reversal. On the other hand, when the indicator is below 30, the asset is considered to be oversold, which could suggest a bullish reversal. To illustrate the idea, we can think of a hamster running on its wheel. If it runs too fast for too long, it eventually runs out of steam (overbought). Conversely, if it stops moving, a simple burst of energy can get it going again (oversold).
Mathematically, the RSI is calculated using the following formula (simplified):
RSI = 100 - [ 100 / (1 + (Average of increases / Average of decreases)) ]
The Average Up is the average of the positive price changes over the selected period, while the Average Down is the average of the negative changes. Trading platforms usually perform this calculation automatically.
In addition to reading overbought and oversold areas, we are also interested in divergences. A bullish divergence can occur when the price reaches a new low while the RSI does not follow the same trajectory (it does not go lower), which can signal a weakening of selling pressure. Conversely, a bearish divergence appears when the price records a new high without the RSI confirming it, which can reflect a slowdown in the uptrend.
It is important to take into account the market context. In a strong uptrend, an RSI above 70 can remain there for a long time before a real reversal occurs, and vice versa in a downtrend. In addition, it is recommended to cross-reference the information given by the RSI with other indicators (moving averages, volumes, Bollinger bands, etc.) and to complete the analysis with fundamental elements.
In summary, the RSI is a popular tool for traders to identify potential excesses (overbought or oversold) as well as turning points via divergences. However, it should not be used in isolation and requires interpretation in a broader framework.