How to Use the Relative Strength Index to Identify Overbought and Oversold Stocks

7 August 2025

Investing in the stock market can be tricky, especially when trying to determine the right time to buy or sell. One tool that can help traders make informed decisions is the Relative Strength Index (RSI). This powerful indicator can help identify overbought and oversold stocks, potentially signaling when a stock is due for a reversal.

In this article, we’ll break down what RSI is, how it works, how to interpret it, and strategies for using it effectively. If you've ever wondered how traders predict price movements, you're in the right place!

What is the Relative Strength Index (RSI)?

The Relative Strength Index (RSI) is a popular momentum indicator used in technical analysis to measure the speed and change of price movements. Introduced by J. Welles Wilder Jr. in 1978, RSI helps traders determine if a stock is overbought or oversold by analyzing recent price changes.

RSI is expressed as a number between 0 and 100, typically plotted below a stock's price chart.

- RSI above 70 – The stock is considered overbought, meaning it might be overvalued and due for a pullback.
- RSI below 30 – The stock is considered oversold, meaning it might be undervalued and due for a bounce.

But wait, it’s not that simple! Let’s dive into how RSI is calculated and how to interpret it correctly.

How is RSI Calculated?

The RSI formula is based on the ratio of the average gains to average losses over a specific period, usually 14 days. Here’s the formula:

\[
RSI = 100 - \left( \frac{100}{1 + RS} \right)
\]

Where:

\[
RS = \frac{ ext{Average Gain over 14 days}}{ ext{Average Loss over 14 days}}
\]

Instead of manually calculating RSI, most trading platforms like TradingView, ThinkorSwim, or MetaTrader have built-in RSI indicators that you can apply with a single click.

Now that we understand how RSI is calculated, let’s discuss how to interpret it.

How to Interpret RSI for Trading

1. Overbought Conditions (RSI > 70)

When RSI is above 70, it suggests that the stock has been rising rapidly and could be overvalued. This might indicate a potential sell opportunity because the stock price could soon reverse or consolidate.

🔹 Example: If Tesla’s RSI climbs to 82, traders might assume it’s overbought and anticipate a pullback.

2. Oversold Conditions (RSI < 30)

When RSI is below 30, the stock has been falling sharply, potentially making it undervalued. This might indicate a buy opportunity as the price could rebound.

🔹 Example: If Apple’s RSI falls to 25, traders might consider it oversold and expect a bounce back upwards.

3. Divergence Signals

Divergence happens when the stock price and RSI move in opposite directions, signaling a potential trend reversal.

- Bullish Divergence: When the stock price makes lower lows, but RSI forms higher lows – indicating a potential reversal to the upside.
- Bearish Divergence: When the stock price makes higher highs, but RSI forms lower highs – suggesting a potential reversal to the downside.

🔹 Example: If the S&P 500 index keeps making new highs, but RSI starts declining, it could indicate weakening momentum and a possible correction ahead.

4. RSI Swing Rejections

This strategy focuses on RSI bouncing off certain levels, confirming potential reversals.

- Bullish Swing Rejection: RSI drops below 30, rebounds, and then holds above 30 – signaling a buy opportunity.
- Bearish Swing Rejection: RSI rises above 70, falls back below, and fails to reclaim 70 – signaling a sell opportunity.

Best Strategies for Using RSI

Now that we understand RSI signals, let's explore some effective trading strategies.

1. RSI + Moving Averages

How it works: Combine RSI with Moving Averages (MA) for stronger confirmation.

- Buy when RSI is below 30 and the stock bounces above a key moving average (e.g., 50-day MA).
- Sell when RSI is above 70 and the stock drops below a key moving average.

🔹 Example: If RSI signals an oversold condition AND the stock crosses above the 50-day moving average, it's a strong buy signal.

2. RSI + Support and Resistance Levels

How it works: Identify key support and resistance levels, then use RSI to confirm entries and exits.

- Buy at support if RSI is oversold.
- Sell at resistance if RSI is overbought.

🔹 Example: If Amazon is trading at a strong support level and RSI is 28, it could be a great buying opportunity.

3. RSI for Trend Confirmation

- In an uptrend, RSI usually holds above 40-50 and reaches overbought zones before retracing.
- In a downtrend, RSI struggles to exceed 50-60 and regularly dips into oversold zones.

🔹 Example: If RSI stays above 50 during a pullback, it’s likely just a correction, not a trend reversal.

Common Mistakes When Using RSI

Even though RSI is useful, traders often make mistakes when relying on it alone. Here are some common pitfalls to avoid:

✅ Ignoring the Overall Trend

RSI alone isn't enough to determine the trend. If a stock is in a strong uptrend, RSI can stay overbought for long periods without reversing.

🔹 Solution: Combine RSI with other technical indicators like moving averages or trendlines.

✅ Relying Only on 70/30 Levels

Not every stock will react to the exact 70/30 RSI levels. Some may reverse around 60 (overbought) or 40 (oversold) depending on market conditions.

🔹 Solution: Analyze RSI based on the stock’s historical performance.

✅ Using RSI in Isolation

RSI works best when combined with other technical indicators, such as:

- MACD (Moving Average Convergence Divergence)
- Bollinger Bands
- Fibonacci Retracement Levels

🔹 Solution: Use RSI as one piece of the puzzle, not the only deciding factor.

Final Thoughts

The Relative Strength Index (RSI) is a fantastic tool for identifying overbought and oversold stocks, but it’s not foolproof. While it provides valuable insights, successful trading involves context, confirmation, and strategy.

✅ Use RSI along with other indicators.
✅ Consider the stock’s overall trend before making a decision.
✅ Watch for divergences for early trend reversal signals.

By applying RSI correctly, you can better time your trades, reduce risks, and increase potential profits. Happy trading!