The Relative Strength Indicator (RSI) measures the momentum and speed of price movements. RSI oscillates between zero and 100. Traditionally, the indicator is considered overbought when above 70 and oversold when below 30. RSI is an extremely popular momentum indicator.
Overbought / Oversold
The chart below shows SPY with a 14-day (the default look-back) RSI. Working from right to left, the SPY got overbought in late January due to the effects of QE2. Despite this overbought reading, the index did not decline. Instead, it stalled for a couple of weeks then continued higher. Four more overbought readings occurred before the stock finally peaked in late March. Momentum oscillators can become overbought (or oversold) and remain so in a strong up (or down) trend. The first four overbought readings foreshadowed consolidations or small pullbacks. The fifth coincided with a significant peak.
RSI then moved from overbought to oversold in May. The final bottom did not coincide with the initial oversold reading as the index ultimately bottomed a couple of weeks later. Like many momentum oscillators, overbought and oversold readings for RSI work best when prices move sideways within a range.
Divergences signal a potential reversal point because directional momentum does not confirm price. A bullish divergence occurs when the underlying security makes a lower low and RSI forms a higher low. RSI does not confirm the lower low and this shows strengthening momentum. A bearish divergence forms when the security records a higher high and RSI forms a lower high. RSI does not confirm the new high and this shows weakening momentum.
The SPY chart above shows a bearish divergence from February-March. The index moved to new highs in March, but RSI formed lower highs for the bearish divergence. The subsequent breakdown in April confirmed weakening momentum.
A bullish divergence formed in the middle of May. The bullish divergence formed with SPY moving to new lows and RSI holding above its prior low. RSI reflected less downside momentum during the decline. The early June breakout confirmed improving momentum. Divergences tend to be more significant when they form after an overbought or oversold reading.