RSI Explained: How to Spot Overbought and Oversold Stocks
Last week we covered MACD, which measures whether momentum is building or fading by comparing two moving averages. This week's indicator, RSI (Relative Strength Index), answers a related but different question: has this stock's recent move gone too far, too fast?
RSI is one of the most widely quoted indicators in financial media — you'll hear phrases like "the stock is overbought" or "RSI is flashing oversold" constantly. Once you understand what's actually being measured, those phrases stop being jargon and start being useful.
What RSI Actually Is
RSI is a bounded oscillator, meaning it always reads somewhere between 0 and 100, unlike price or MACD, which can drift anywhere. It's calculated by comparing the size of a stock's recent up days to the size of its recent down days, typically over a 14-day lookback period, and scaling that comparison onto the 0-100 range.
You don't need to run the math yourself; every charting platform, including Trucharts, plots it for you. What matters is the intuition: when a stock has been rising sharply with few or shallow down days, RSI climbs toward 100. When it's been falling hard with few relief bounces, RSI drops toward 0. Traditionally, a reading above 70 is labeled "overbought" and a reading below 30 is labeled "oversold" shorthand for "this move has been unusually one-sided lately," not a literal prediction that a reversal is imminent.
A Concrete Example: Overbought and Oversold in Action
Picture a hypothetical stock, "ABC Corp," that rallies for three straight weeks on good news. As the rally accelerates, RSI climbs from the 50s into the 70s and eventually touches 80. Around that point, the stock's advance stalls, it starts trading sideways for a few days even though no new bad news has come out. That stall, arriving right as RSI pushes into overbought territory, is the classic pattern: not a crash, just the rally running out of fresh buyers at an unsustainable pace.
Now picture the opposite: a different hypothetical stock, "DEF Retail Co.," drops sharply after a disappointing sales update. RSI falls from the 40s into the 20s within a couple of weeks. Eventually the selling pressure eases, RSI ticks back above 30, and the stock stabilizes and starts to recover even though nothing news-worthy changed. That's oversold conditions resolving.
As with MACD, there's a more advanced pattern worth knowing about even at this stage: RSI divergence. If a stock keeps making new price highs while RSI makes lower highs each time, that's bearish divergence, a sign the rally is being carried by fewer and fewer buyers even as price keeps climbing. The mirror version, price making lower lows while RSI makes higher lows, is bullish divergence. We'll go deeper on divergence later in this series.
Check out this example of the RSI indicator:
The Limits of RSI
The biggest mistake newer traders make with RSI is treating "overbought" as an automatic sell signal. In a genuinely strong uptrend, RSI can stay pinned above 70 for weeks while the stock keeps climbing selling purely because RSI is "high" would have meant missing much of the move. The same is true in reverse during strong downtrends. RSI measures how stretched a move is, not when it will end, and it works best alongside trend context (is the broader trend up, down, or sideways?) rather than in isolation. That's exactly why this series builds toward combining indicators rather than trading any one of them alone.
Test RSI Signals Before You Trust Them
"Overbought" and "oversold" sound precise, but how often do they actually lead to a turn for a given stock? TruCharts' backtesting tool lets you test a rule like "RSI below 30" against a stock's real price history, so you can see how it actually performed before risking real capital on it.
Benefit: instead of trusting a rule of thumb, you get an actual historical track record for the specific stock and timeframe you care about.
Subscribe to TruCharts for free to save backtests like this one and get the rest of this technical analysis series as it publishes.
Coming Up Next
Next week we'll step back from momentum oscillators and cover the moving averages themselves — specifically SMA vs. EMA — since both MACD and RSI are built on assumptions about how a moving average should smooth price, and it's worth understanding those building blocks directly.
This article is for educational purposes only and does not constitute financial or investment advice. The "ABC Corp" and "DEF Retail Co." examples are hypothetical. No indicator, including RSI, guarantees future results. Always do your own research or consult a licensed financial advisor before making investment decisions.
