The Relative Strength Index Can Tell You Who’s Driving The Price: Buyers Or Sellers

Jonathan Hobbs, CFA

4 mins

The Relative Strength Index Can Tell You Who’s Driving The Price: Buyers Or Sellers
  • J. Welles Wilder Jr. created the Relative Strength Index (RSI) back in 1978 and over the past 45 years, it’s become an investor favorite.

  • The RSI ranges between zero and 100. When it's closer to 100, buyers are controlling the price action – but when it gets too high, they’re often flying too close to the sun. When it’s closer to zero, it’s the opposite and sellers are in control.

  • The best way to use the RSI in your strategy is to look for bullish and bearish divergences between the price of an investment and the indicator. When they’re headed in opposite directions, it can be a sign that a trend is running out of steam.

J. Welles Wilder Jr. created the Relative Strength Index (RSI) back in 1978 and over the past 45 years, it’s become an investor favorite.

The RSI ranges between zero and 100. When it's closer to 100, buyers are controlling the price action – but when it gets too high, they’re often flying too close to the sun. When it’s closer to zero, it’s the opposite and sellers are in control.

The best way to use the RSI in your strategy is to look for bullish and bearish divergences between the price of an investment and the indicator. When they’re headed in opposite directions, it can be a sign that a trend is running out of steam.

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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.

What’s the Relative Strength Index?

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.

J. Welles Wilder Jr., creator of the RSI, in 1978.
J. Welles Wilder Jr., creator of the RSI, in 1978.

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))

Where:

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.

Chart drawn with TradingView.
Chart drawn with TradingView.

How do you use the RSI?

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:

1. Finding a time to buy with bullish divergence

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.

Chart drawn with TradingView.
Chart drawn with TradingView.

2. Finding a time to sell with bearish divergence.

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:

Chart drawn with TradingView.
Chart drawn with TradingView.

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.

Chart drawn with TradingView.
Chart drawn with TradingView.

How can you add the RSI to your trading toolkit?

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:

How to get the RSI indicator on TradingView.
How to get the RSI indicator on TradingView.
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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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