This article will teach you the ins and outs of the relative strength index (RSI). Its definition, calculation, interpretation, and finally, how to find oversold stocks with an improving RSI using a stock screener.
What is the Relative Strength Index (RSI)?
The relative strength index is a technical indicator that measures the momentum of a stock price.
Specifically, it’s a line that oscillates between a value of 0 and 100 depending on the direction and magnitude of moves in the underlying stock price.
This oscillator resembles the red line in the bottom panel below. This chart comes from TradingView, which you can read all about in my TradingView review.
Traders frequently use the RSI to detect overbought and oversold conditions in stock prices, which can help with timing entry and exit points of trades. It is also used to detect potential reversals in a trend, similar to the historical volatility indicator.
How do You Calculate the RSI?
Essentially, the RSI measures the directional velocity of recent share price movements. It does this by comparing the average gains of the up days with the average losses of the down days over a certain time period.
For example, if average gains have outweighed average losses recently, then the RSI will move up. And vice versa if average losses outweigh average gains.
You can think of this like a tug of war. The RSI will move in the direction with the greatest “pull”.
The RSI is calculated with the following formula:
RSI = 100 – (100 / (1 + RS))
RS = Relative Strength = Average Gain in the Period / Average Loss in the Period
The inventor of the RSI, J. Welles Wilder, calculates the average gain and loss with the following smoothing method:
Average Gain = (Previous Average Gain * (N – 1) + Current Gain) / N
Where “N” is the length of the period, “Previous Average Gain” is the average gain 1 period ago, and “Current Gain” is the gain between the current period and previous period.
The average loss is computed in exactly the same way, but for losses.
Time Frame
Generally, the RSI uses a 14-period time interval to calculate these averages, however some traders prefer a longer time frame (e.g. 20-period), or shorter time frame (e.g. 10-period), depending on their preferences. The longer the interval, the smoother (i.e. less noisy) the indicator is.
Bear in mind, the “period” depends on the chart you’re looking at. If it’s a daily chart, the RSI will be a 14-day RSI, but if its an intra-day chart, it might be a 14-minute RSI.
This swing trading vs day trading guide explains a bit more about the time frames of different trading styles.
How to Interpret the RSI
There are a number of different ways to interpret the relative strength index. Unlike other technical indicators, like the MACD, there are no definitive buy and sell signals with the RSI.
In many cases, the interpretation of the RSI is in the eye of the beholder. One person’s analysis may contradict with another’s. However, while there is a certain degree of discretion involved, there are some general guidelines.
Overbought and Oversold Conditions
The most common of these is the levels associated with overbought and oversold conditions. In general, an RSI reading below 30 is deemed as oversold, whereas a reading above 70 is seen as overbought.
Therefore, if the RSI is above 70 it might be a good time to sell. Likewise, if the RSI is below 30 it might signal a buying opportunity.
However, there is a caveat here.
A share price in a strong bullish trend can generate RSI readings above 70 for a long period of time before selling off. Similarly, a prolonged bearish trend can give RSI readings below 30 for some time before any rally.
In these cases, traders tend to recalibrate the standard 30/70 levels to define more appropriate overbought/oversold zones.
For example, in the chart of Tencent below, you will see that the RSI frequently traded above 70 in its bull run from 2005-2018. Importantly, the share price rarely pulled back until the RSI got to around 80.
Similarly, the RSI never got down to the standard oversold line of 30. Waiting for the RSI to get below 30 would have meant you missed out on some great buying opportunities.
As you can see, moving the overbought/oversold range up from 30/70 (blue lines) to 40/80 (green lines) was more informative during this bull run.
Lastly, some traders use a wider range for the oversold/overbought levels, for example 20/80, because they are only interested in extreme readings.
Read my MetaStock review to see the other charting and screening techniques it’s capable of.
RSI Divergence
For all technical indicators, a divergence occurs when the share price moves in the opposite direction to the underlying indicator.
In other words, the trends of the share price and indicator “diverge” in opposite directions.
This divergence tends to act as a leading indicator for a reversal in the share price trend.
Another technical indicator that helps time reversals is the Rahul Mohindar Oscillator.
Bullish Divergence
A bullish, or positive, divergence in the RSI refers to a situation where the share price is making lower lows at the same time that the RSI is making higher lows.
This is usually a sign that the size of the down moves are becoming less extreme and that the share price is primed for a bullish reversal.
Bearish Divergence
Conversely, a bearish, or negative, divergence in the relative strength index occurs when the stock price makes higher highs at the same time that the RSI makes lower highs.
This is usually a sign that bullish momentum is being lost – upward moves are becoming less extreme and downward moves are becoming more extreme. Using the earlier analogy of a tug-of-war, greater pull is being exerted to the downside.
The chart of Eli Lilly below shows this in action.
There were 2 occasions, in 2018/19 and 2020, when the RSI started to trend down while the share price kept making new highs. In both cases, the share price subsequently sold off.
As of writing, we may be starting to see another negative divergence developing. If so, it may be a good time to take some profits.
Again, note here how the RSI hasn’t dipped below 30. We already know the reason from earlier.
Since the stock has been in a bullish trend for the last few years, the RSI has traded at above average levels. Therefore, if you were actively trading this stock, it would have made sense to shift your overbought/oversold levels higher.
RSI Trendline Break
A trendline break in the RSI refers to a situation where the current RSI value breaks through a previously established trendline.
In that respect, it is just the same as any other trendline analysis you might perform on a stock chart. If you’re not sure how to draw trendlines, then read this article about how to draw support and resistance levels correctly.
A break in the RSI trend usually precedes a reversal in the underlying stock.
If a downtrend is broken, this signals a bullish reversal might be coming. If an uptrend is broken, prepare for a bearish reversal.
Bullish Reversal
As you can see in the chart of Mazda below, there are 2 occasions when the RSI broke above established downtrends.
The vertical lines signal where the breaks occurred, which have both proved to be good buying opportunities.
Bearish Reversal
This weekly chart of Tencent clearly shows the RSI breaking an uptrend where the vertical line is drawn.
Turns out it was a great medium-term selling opportunity.
If you want to see more advanced strategies that use RSI trend breaks with the MACD indicator, then read this article on how to use MACD effectively.
Using a Stock Screener to Find Oversold Stocks With Improving RSI
So, how can we use a stock screener to find stocks that are oversold and have bullish momentum? In other words, stocks that are on their knees but showing signs of a potential reversal.
For the oversold condition, we want to find companies with a low RSI value.
To ensure they also have bullish momentum, we want to see an improving RSI, or in other words, bullish divergence.
One of my favourite screeners for performing this screen is Market In Out. I show you how to run this below.
First, select the stock universe that you want to perform the screen on. I’ve chosen S&P 500 and Nasdaq 100 companies from the US stock market, and FTSE 100 companies from the UK stock market. Click ‘Add Criterion’ when you’ve selected.
Now, under the ‘Oscillators’ tab select the RSI, including the lookback period for its measurement. Here, I’m leaving it with the standard 14 time period.
In the far right column, select the ‘Is Below’ condition and type 40 into the box. This is our oversold condition. Why is it 40 and not 30, you might be asking? Well, because I’m looking for an RSI that’s improving, so I want to give a bit of leeway for this. It’s hard to find stocks with an improving RSI that’s also below 30.
Now, I want to set the bullish divergence condition for the RSI. To do this, I simply click ‘Oscillators’ –> ‘RSI (14)’ –> ‘Bullish Divergence’ –> ‘Add Criterion’.
Select the chart time-frame that you want the RSI to be calculated for. This ranges from 5-minutes all the way up to monthly.
Personally, I use a weekly time-frame because it gives me the medium-term trading signals I like. As such, the RSI will be a 14-week RSI.
When you’ve input all of the criteria below, click ‘Run Screen’.
Stock Screener Output
Here’s a snippet of the stocks that came up on the screen.
As you can see in this chart of JP Morgan, the 14-week RSI is below 40, and making higher lows while the share price makes lower lows – i.e. bullish divergence.
The same can be said of this Docusign chart. The RSI is slowly building an uptrend from low levels, while the share price is in a downtrend.
