RSI Indicator: Complete Guide to Reading Overbought, Oversold and Divergence

Getting to Know RSI: An Indicator Created by Welles Wilder

Relative Strength Index (RSI) was developed by J. Welles Wilder Jr. and introduced in his book "New Concepts in Technical Trading Systems" in 1978. To this day, RSI remains one of the most popular and trusted indicators in the world of trading, used by millions of traders from beginners to institutional fund managers.

RSI is a momentum oscillator that measures the speed and magnitude of price changes. The value ranges from 0 to 100, giving an idea of the relative strength of price movements — whether the market is too up (overbought) or too down (oversold).

How RSI Works and Formula

RSI is calculated using the formula:

RSI = 100 – [100 / (1 + RS)]

Where RS (Relative Strength) = Average price increase / Average price decrease in a period of N days.

The default RSI setting is period 14, which means using the last 14 candles. This setting was recommended by Wilder himself and remains the industry standard. Some traders use RSI 9 for faster signals or RSI 21 for slower but more reliable signals.

Overbought and Oversold Levels

RSI Above 70 — Overbought

When the RSI exceeds the 70 level, the market is said to be in an overbought condition — prices have risen too quickly and are likely to experience a downward correction or reversal. But keep in mind: in a strong uptrend, the RSI can stay above 70 for a very long time. Don't sell immediately just because the RSI touches 70!

RSI Below 30 — Oversold

RSI below 30 indicates oversold conditions — prices are falling too quickly and have the potential to reverse upwards. Just like overbought, in a strong downtrend the RSI can stay below 30 for a long time.

Level Adjustment

Experienced traders often use modified levels depending on market conditions:

• Bullish market: Raise the level to 40-80 (oversold 40, overbought 80)


• Bearish market: Lower the level to 20-60 (oversold 20, overbought 60)


• Ranging market: Standard levels 30-70 work optimally

RSI Divergence: The Strongest Signal

Divergence occurs when the RSI movement is opposite to the price movement. This is one of the most powerful trading signals because it indicates trend exhaustion before an actual reversal occurs.

Bullish Divergence (Regular Bullish Divergence)

Price makes a lower low (a new low), but the RSI makes a higher low (a higher low). This indicates that even though the price continues to fall, selling pressure is starting to weaken — it is likely that the trend will reverse to the upside.

How to trade Bullish Divergence:

1. Identify two swing lows in price — the second is lower


2. Compare with RSI — if RSI makes a higher low, the divergence is confirmed


3. Look for entry confirmation: candlestick reversal pattern, or RSI cut above level 30


4. Entry above the high of the confirmation candle, stop loss below the latest low

Bearish Divergence (Regular Bearish Divergence)

Price makes a higher high (new peak), but the RSI makes a lower high. Indicates buying momentum is weakening even though prices are still rising — a warning signal to prepare to short or close long positions.

Hidden Divergence (Continuation Signal)

In contrast to regular divergence which indicates a reversal, hidden divergence confirms trend continuation:

• Hidden Bullish: Price makes a higher low, RSI makes a lower low → uptrend will continue


• Hidden Bearish: Price makes a lower high, RSI makes a higher high → downtrend will continue

RSI Failure Swing

This concept, which was introduced directly by Wilder, provides a very strong reversal signal without needing to look at price movements:

Bullish Failure Swing

1. RSI fell below 30 (oversold)


2. RSI bounces above 30


3. RSI fell again but did not reach 30 (higher low on RSI)


4. RSI breaks previous top → buy signal!

Bearish Failure Swing

1. RSI rose above 70 (overbought)


2. RSI falls again


3. RSI rose again but did not exceed 70 (lower high on RSI)


4. RSI breaks previous low → sell signal!

RSI as Support and Resistance

RSI has key levels that often function as support and resistance:

• Level 50 — The all-important midline. RSI above 50 = bullish bias, below 50 = bearish bias


• Level 40 — In uptrends, the RSI often “bounces” from this level


• Level 60 — In a downtrend, the RSI often hits this level as resistance

2 Period (Short-term) RSI Strategy

Larry Connors popularized the strategy of using 2 period RSI for very short term trading:

• Use RSI(2) on the daily chart


• Buy when RSI(2) falls below 10 (very oversold) and the price is above the 200 SMA


• Sell when RSI(2) rises above 90 (very overbought)


• Tight stop loss because signals often occur within 1-3 days

Combining RSI with Other Indicators

RSI + Moving Average: Entry buy when the RSI shows oversold AND the price is above the 200 MA (confirmation of a bullish trend). This avoids buying in a big downtrend.

RSI + Support/Resistance: RSI divergence that occurs right at the main support/resistance level provides an entry signal with a very high probability.

RSI + Candlestick Pattern: Confirm the RSI signal with a candlestick pattern — for example, a bullish RSI divergence confirmed by a morning star or bullish engulfing.

Common Mistakes in Using RSI

• Trading against the trend only because the RSI is overbought/oversold


• Not considering the larger trend context


• Ignore divergence because it looks "too early"


• Using RSI as the sole basis for trading decisions

Important Principles: RSI is a tool, not an oracle. Use it as part of a more complete trading system, not as the only decision reference.