Indicators, and what the readings mean

RSI: what the number is, and why 70 is not a sell signal

RSI is a ratio of recent gains to recent losses, squeezed onto a 0-100 scale. Once you have seen the formula, the two most common mistakes made with it stop being possible.

About 11 minutes to read. Free, no account.

What the number is

The relative strength index compares the average size of up moves with the average size of down moves over the last N bars - 14 by convention. Call those averages AG and AL:

The formula

RS   =  average gain  /  average loss
RSI  =  100  -  100 / (1 + RS)

Work one through. Over the last 14 bars the up bars averaged 1.20 points of gain and the down bars averaged 0.80 points of loss:

A worked reading

RS   =  1.20 / 0.80          =  1.5
RSI  =  100 - 100 / 2.5      =  60

So RSI 60 means up moves were one and a half times the size of down moves recently. Nothing more. RSI 50 means they were equal. RSI 80 means RS = 4, which is to say up moves were four times the size of down moves. The scale is just that ratio re-expressed so it fits between 0 and 100.

A ratio is not a price, and not a size

Because RSI is a ratio of average move sizes, it is blind to two things that matter enormously.

How far price has travelled. A coin that ground up 4% over fourteen bars with almost no pullbacks and a coin that exploded 40% can print the same RSI, because both had one-sided bars.
How much this coin normally moves. RSI has no reference to the asset’s usual range. The number is scale-free, which is convenient and means it cannot tell you whether a move is unusual for this market.

The scale, with the conventional 30 and 70 lines. Most readings, most of the time, sit in the wide middle - where RSI is telling you almost nothing.

Why "overbought" is not a sell signal

This is the mistake that costs people the most, and the formula explains it completely. RSI is bounded and price is not. RSI cannot go above 100, so in a sustained advance it must flatten out near the top of its range while price keeps climbing. A high reading is therefore what a strong trend looks like, not a warning that the trend is finished.

Watch it happen. Start from the reading above (AG 1.20, AL 0.80) and then run fourteen straight bars that each gain exactly 1.00 point, using Wilder’s smoothing with N = 14. Each bar the average loss is multiplied by 13/14 and nothing is added to it:

Fourteen straight up bars

average loss  0.80 x (13/14)^14   =  0.28
average gain  settles towards     =  1.07
RS            1.07 / 0.28         =  3.8
RSI           100 - 100 / 4.8     =  79

Fourteen more identical bars and the average loss decays to 0.10, RS reaches about 10, and RSI prints 91. Twenty-eight bars of steady gains: price is up roughly 32% and RSI 91 does not mean the move is 91% done. It means the last 28 bars were one-sided. In a real trend RSI can sit above 70 for weeks.

The mirror image matters just as much. In a hard decline RSI pins under 30 and stays there, and "oversold" buyers are buying each step down. An extreme reading at the start of a trend looks identical to an extreme reading at the end of one, because the formula has no way to tell them apart.

So what does an extreme reading tell you?

It tells you the recent bars were lopsided, which is a fact worth having. Treat it as a question, not an answer: is this a trend establishing itself, or a move running out of participants? RSI cannot distinguish those, so something else has to - structure, the behaviour of pullbacks, volume, the context the market is in.

The other honest use is comparative. A coin reading 75 while nothing around it is above 55 is behaving differently from its neighbours, and "why is this one different" is a good question to ask of a market.

Divergence: what it is, and what it is not

A bearish divergence is when price makes a higher high while RSI makes a lower high. Mechanically it means the second push was less one-sided than the first - fewer or smaller up bars got price to a higher level. A bullish divergence is the same thing upside down: a lower low in price, a higher low in RSI.

That is a real observation. Now the honest part, which is three things.

A divergence needs two pivots, and you cannot know a pivot is a pivot until price has moved away from it. By the time the second high is confirmed as a high, the market has already turned down from it. The pattern completes in hindsight, always.
Which pivots you choose decides whether there is a divergence at all. On any chart with a few swings you can find a pair of highs that diverge. Choosing the pair after seeing what happened next is not analysis.
Divergences fail often, and in a strong trend they fail repeatedly. Momentum fading below a new high is ordinary in an advance that is still going. Counting only the divergences that preceded a reversal is how a pattern acquires a reputation it has not earned.

Period and timeframe change the number

RSI(14) on a 15-minute chart and RSI(14) on a 4-hour chart of the same coin at the same second are different numbers, and neither is more true. Shortening the period makes RSI reach the extremes more often; lengthening it makes extremes rarer and slower. Crypto trades every hour of every day, so there is no session close to anchor a "daily" bar to beyond the exchange’s choice of midnight.

Decide the timeframe you are trading, read RSI on that timeframe, and do not go hunting across timeframes for the one that agrees with you. That hunt always succeeds, which is precisely why it is worthless.

The terms, defined

RSI: Relative strength index. 100 - 100/(1+RS), where RS is the average gain divided by the average loss over N bars. A bounded 0-100 restatement of that ratio.
Average gain / average loss: The smoothed mean size of up bars and of down bars over the period. Wilder multiplies the previous average by (N-1)/N and adds the new bar divided by N.
Overbought / oversold: Conventional labels for readings above 70 and below 30. They describe one-sidedness in the recent bars, and are not instructions.
Divergence: Price and the indicator making opposite-direction extremes at two successive pivots. It completes only after the second pivot is confirmed.
Pivot: A local high or low. It is only identifiable as one after price has moved away from it, which is why patterns built on pivots are late.
Bounded indicator: One with a floor and a ceiling. Because price has neither, a bounded indicator must saturate during a large move.

What this means in practice

Read RSI as "up moves were this many times the size of down moves", not as a percentage of anything.
Never sell because RSI is above 70 or buy because it is below 30. In a trend that is exactly where the readings belong.
Treat an extreme as a question that needs other evidence to answer.
Ignore a divergence you could only have drawn after the fact - which is most of them.
Fix your timeframe and period before you look, and do not shop across timeframes for the reading you want.
Two points of RSI between platforms is a rounding difference, not information.

Nothing in this lesson is financial advice or an instruction to trade. See the risk disclaimer. We never recommend a leverage setting - that decision is yours.