The Relative Strength Index (RSI) is a momentum indicator which helps to show when a market is overbought or oversold.
“Overbought” is a market condition where a move higher becomes extended to such an extent that buying interest becomes exhausted. Effectively, there is no one left prepared to buy at increasingly higher prices leaving the financial instrument vulnerable to a sell-off. This selling can become severe and accelerate as holders of long positions rush to book profits or cut losses.
“Oversold” is the opposite. In this the situation where a market sell-off becomes over-extended to such an extent that selling pressure is exhausted. Then a market can be subject to a swift reversal and prices bounce as short-sellers rush to cover their positions and fresh buying comes in as upside momentum builds.
The key metric within the RSI is calculated by dividing the average gain of “up” periods within a specific time frame by the average loss of “down” periods over the same time frame. The generally accepted look-back period is 14 (which would mean 14 days on a daily chart) and this is the default setting on Spread Co’s platform. You can override this default setting, and reducing the look-back period will give more trading signals, although these may be less reliable than those observed when using a longer time frame. This RSI metric is converted into a simple indicator which ranges between zero and 100. Typically, a financial instrument is considered to be in overbought territory if the RSI is above 70 and oversold if the RSI is below 30. However, some analysts shift the threshold up to 80 in bull markets or down to 20 in bear markets. The index also helps to measure the speed and change of price movements.
Here’s a section of the RSI indicator showing examples of overbought and oversold conditions. The RSI indicator sits underneath the price chart itself: