J. Welles Wilder designed the RSI indicator in the late 1970s. His goal was to create a charting tool that could help traders examine the performance of a stock. Initially, the method was presented in Wilder’s book entitled New Concepts in Technical Trading Systems. In addition to the RSI indicator, the book also brought to light other popular charting tools, such as the Average True Range (ATR), the Average Directional Index (ADX), and the Parabolic Stop and Reverse (also known as Parabolic SAR).
When applied with standard settings, the RSI indicator takes into account the price of an asset over 14 periods. So if the indicator is applied to a candlestick chart, it would measure the price oscillations based on the previous 14 candles (i.e.,14 hours on hourly charts, 14 days on daily charts, and so forth). Technically, the RSI divides the average gain by the average loss and plots data on a 0-100 scale.
Traders use the RSI to spot potential overbought and oversold market conditions. When the RSI reads above 70, it suggests an overbought condition. In contrast, when it moves below 30, it may be indicative of an oversold condition.
Another way of using the RSI indicator is trying to spot potential points of price reversal. To do so, traders look for the so-called bullish and bearish divergences. A bullish divergence happens when the RSI and the asset price move in opposite directions.
In other words, the market price makes a lower low, while the RSI makes a higher low. This suggests that, despite the price drop, the buying pressure is increasing. Conversely, a bearish divergence would indicate that the selling pressure is increasing, despite an increase in market price.
It is worth noting, though, that the signals created by the RSI indicator are not always accurate, so traders often combine it with other TA tools to reduce risks.