Imagine you are driving a car on a highway. You press the accelerator, and the car surges from 40 km/h to 80 km/h in a few seconds. That sudden burst of speed is thrilling. But then, you settle into a steady cruise at 100 km/h. You are still moving fast, and you are still going forward. However, your acceleration has dropped to zero. This is exactly how the Relative Strength Index (RSI) works. It measures the speed of a stock's price movement, not its direction.

What Does RSI Actually Calculate?

Many retail investors believe that a high RSI (above 70) is a direct signal to sell because a stock is "overbought." Conversely, they think a low RSI (below 30) means a stock is "oversold" and must be bought immediately. To understand why this is a dangerous assumption, we need to look at how RSI is computed. RSI looks at a specific period—typically 14 days—and compares the average gains on up-days to the average losses on down-days.

A Step-by-Step Calculation

Let us calculate this for a fictional company, Bharat Paints, over a 14-day period. Suppose the stock had 9 up-days and 5 down-days.

An RSI of 75 is in the "overbought" zone. But does this mean Bharat Paints is about to crash? Absolutely not. It simply means that over the last 14 days, the size of the upward moves was three times larger than the size of the downward moves.

The Overbought Trap in Strong Trends

This is where many retail investors lose money. In a strong bull market, a high-quality stock can stay "overbought" (RSI above 70) for weeks or even months. As long as the stock keeps making steady, incremental gains day after day, the average loss remains tiny. Because the denominator (Average Loss) is so small, the RSI will hover near 80 or 90.

If you shorted the stock or sold your holdings just because the RSI crossed 70, you would have missed out on the most profitable part of the rally. RSI measures momentum, not absolute value. A high RSI tells you the trend is exceptionally strong, not that it is over.

How to Use RSI Correctly: Divergence

If overbought does not mean sell, how do you actually use RSI? The most reliable signal is divergence. This happens when the price action and the momentum indicator stop moving in harmony.

Suppose the stock price of Bharat Paints makes a new high of ₹550, and the RSI reaches 80. A few days later, the price climbs even higher to ₹570, but the RSI only reaches 72. The price made a higher high, but the RSI made a lower high. This is a bearish divergence. It tells you that while the price is still going up, the speed of the move is slowing down. The car is still moving forward, but the driver has taken their foot off the accelerator. This is your warning sign that the trend might be exhausting itself.

You can easily track the daily RSI and scan for momentum divergences on any stock by visiting its technical analysis page on stock-analyze.com.