The Relative Strength Index (RSI) is an old-time favorite among technical analysts and traders. As the name suggests, the indicator compares the relative strength of buyers and sellers – and that can tell you which side is driving the overall trend. By adding the RSI to your strategy, you’ll get a better idea of when it might be the right time to buy or sell. Let’s jump in.
J. Welles Wilder Jr., an American mechanical engineer and real estate developer, devised the RSI back in the 1970s. He explained the indicator in his 1978 trading book, "New Concepts in Technical Trading Systems”, and in the June 1978 issue of Stocks & Commodities magazine – a must-read for traders back in the day.
Being a mechanical engineer, Wilder liked using math to solve tough problems – and there’s no harder problem than figuring out what drives market moves. So Wilder came up with this formula for the RSI, which shows the relative strength of buyers and sellers of an investment:
RSI value = 100 - 100/((1+RS))
RS = (Average gain of the last 14 up periods) / (Average loss of the last 14 down periods)
If math isn’t your thing, here’s the English version: the RSI ranges between zero and 100. When the number is closer to zero, it means an investment is “oversold” and sellers might be overstaying their welcome. Here, the average losses of the past 14 trading periods (those can be hours, days, or even weeks) are much bigger than the average gains – which could signal a bottoming in the price. On the other hand, when the RSI is closer to 100, it’s the opposite: the investment is “overbought”, according to the indicator.
Technical analysts define any RSI value above 70 as overbought and any value below 30 as oversold. Here’s an example of the RSI (blue line) moving outside that range for the US dollar index (red and green bars). As with all the charts you’ll see in this piece, each bar represents one week of movement in the investment, but you can use the RSI with any trading time frame.
As the chart above shows, simply selling an investment when the RSI goes above 70 doesn’t always work out so well. The RSI can stay above 70 for much longer than you might think, while the price trends higher and higher. When the RSI is below 30, that can often be a good sign for longer-term investors to buy in, but be warned: the price and the RSI can still fall much further below 30, and stay there for a long time as the price grinds lower.
So with that said, here are two smarter ways to use the RSI in your strategy:
The price can tell you only so much about investor sentiment. But by looking for “divergences” between the price and the RSI, you can get a better idea about when that sentiment is switching, say from bearish to bullish.
The next chart shows the S&P 500 index (red and green bars) bottoming in early 2016 – before going on a major rally. The index made a lower low at the start of 2016 than the low of 2015, which by all accounts is bearish, as the price was trending downward. But when you throw in the RSI underneath it (blue line), you can see that the indicator was making higher lows. Here, buyers were gaining strength over sellers while the price was trending down – suggesting that sellers were running out of momentum. Technical analysts call this a bullish divergence, and it can signal an upcoming rally. The same thing happened with the S&P 500 in October of 2022, which I explained here.
Of course, divergences can work the other way around – and help investors decide when it's time to sell and take profits. That’s called bearish divergence, and it can signal that buyers are running out of steam and an uptrend is about to reverse back down. Here’s an example of that happening when bitcoin peaked at around $69,000 in late 2021:
Before using RSI divergences in your strategy, keep this in mind: in really strong trends, it can take more than one drive of divergence for the price to change direction.
Take the US dollar’s massive bull run of 2022. In July, it had its first drive of bearish divergence – and the index hardly budged. But then in October, another drive of bearish divergence came along, and only then did the index have a bigger move down.
TradingView is your friend if you want to bring the RSI into your strategy. And it’s a free tool. Here’s how to use it to grab the indicator for any price chart:
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