How is RSI calculated and interpreted, and what does RSI divergence signal about trend strength?

The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and magnitude of recent price changes on a scale of 0 to 100. Developed by J. Welles Wilder, it uses a 14-period default lookback and provides overbought/oversold readings as well as divergence signals.\n\nRSI Calculation:\n\nStep 1: Separate gains and losses over the lookback period (14 periods)\n\nStep 2: Calculate average gain and average loss\n- Average Gain = Sum of gains over 14 periods / 14\n- Average Loss = Sum of losses over 14 periods / 14\n\nStep 3: Calculate Relative Strength (RS)\nRS = Average Gain / Average Loss\n\nStep 4: RSI = 100 - [100 / (1 + RS)]\n\nSubsequent periods use exponential smoothing:\nAvg Gain = [(Prior Avg Gain x 13) + Current Gain] / 14\n\nOverbought/Oversold -- The Nuance:\n\nThe 70/30 thresholds are starting points, not rigid rules:\n\n| Market Regime | Overbought Zone | Oversold Zone | Rationale |\n|---|---|---|---|\n| Trending up | 80+ | 40-50 | Strong trends sustain high RSI |\n| Trending down | 50-60 | 20- | Weak trends keep RSI depressed |\n| Range-bound | 70+ | 30- | Traditional levels work best |\n\nWorked Example:\nAnalyst Rowan tracks Bellevue Industrial (BVI) over 14 daily periods:\n\nPeriod gains: +1.2, +0.8, +0.5, +1.5, +0.3, +0.9, +0.6, +1.1 (8 gains)\nPeriod losses: -0.4, -0.7, -0.3, -0.9, -0.2, -0.6 (6 losses)\n\nAverage Gain = (1.2 + 0.8 + 0.5 + 1.5 + 0.3 + 0.9 + 0.6 + 1.1) / 14 = 6.9 / 14 = 0.493\nAverage Loss = (0.4 + 0.7 + 0.3 + 0.9 + 0.2 + 0.6) / 14 = 3.1 / 14 = 0.221\n\nRS = 0.493 / 0.221 = 2.231\nRSI = 100 - [100 / (1 + 2.231)] = 100 - 30.95 = 69.05\n\nBVI's RSI is approaching overbought but not yet there.\n\nRSI Divergence -- The More Powerful Signal:\n\nDivergence occurs when price and RSI move in opposite directions:\n\n- Bearish divergence: Price makes a higher high, but RSI makes a lower high. This indicates momentum is fading even as price pushes higher -- potential trend exhaustion.\n\n- Bullish divergence: Price makes a lower low, but RSI makes a higher low. Selling pressure is diminishing despite lower prices -- potential bottom forming.\n\nRowan observes BVI making a new price high at $48.50 (prior high was $47.20), but RSI peaks at 66 (prior RSI high was 72). This bearish divergence suggests the uptrend is losing steam. Rowan reduces position size rather than adding.\n\nKey Exam Points:\n- RSI is a bounded oscillator (0-100) unlike MACD (unbounded)\n- Andrew Cardwell's revised interpretation: RSI ranges shift with trend direction\n- Divergence signals precede reversals but can persist for extended periods\n- RSI works best in conjunction with trend analysis and volume\n\nPractice RSI analysis in our CFA question bank.