Relative Strength Index (also known as RSI) is all about comparing the average positive price changes of a stock or index to its average negative price changes.
Traditionally, the price changes are calculated over 14 days, and the average picks up the current day and drops of the first day to create a rolling average. The relative strength is the positive average divided by the negative average, and the relative strike index is 100 – (100 / 1 + relative strength). That creates an index that always has a value between 0 and 100. When the positive price changes are larger than the negative price changes, the (relative strength index is high and above 50.
When the negative price changes are larger than the positive price changes, the relative strength index is low and below 50. High RSI is often interpreted as the stock being “overbought” and more likely to see its price drop in the future.
Low RSI is often interpreted as the stock being “oversold” and more likely to see its price rise in the future. Investors who use RSI set arbitrary high and low levels, often 70 and 30, above and below which the RSI is seen as a strong indicator of a price reversal.
The way some investors use the relative strength index is to short stocks or indices whose RSI is over 70 and to buy stocks or indices whose RSI is below 30. The belief is that the price of the stock will not continue to move as strongly as it has higher or low, and will revert back to some lower or higher price.