A popular technique in most financial markets, RSI divergence is an effective tool for buying or selling at the right time.
Many investors surround themselves with a complex ecosystem of technical indicators. However, some trading strategies aim for simplicity ! The technique we’re discussing here offers signals that are very easy to interpret. Let's take a closer look at RSI divergence.
Here’s a comprehensive summary of the information you need to trade effectively using RSI divergence.
In common parlance, divergence is when two elements move away from each other. The same is true in the trading world!
Divergence generally refers to the distance between two trends:
Divergences are commonly used in markets such as :
The question is therefore which technical analysis tool is the most appropriate to compare with the evaluation of an asset's price. While there are many indicators that can be used to give market entry signals (buy or sell) due to their divergence - such as the MACD (Moving Average Convergence Divergence) - it is the RSI (Relative Strength Index) indicator that is generally preferred. The RSI is the most commonly used indicator in technical analysis. Its purpose is to study the relative strength of upward and downward movements in the price of an asset.
Changes in RSI, coupled with changes in the price of the asset, can result in two types of divergence :
Example of hidden divergence:
In this case, the divergence is finer since the direction taken by the price is not inverse to that of the RSI, however, they will indicate contradictory information as to support and resistance levels, as well as probable breakout points.
First, it may be useful to review what the RSI indicator is, how it is calculated and the various interpretations that can be made.
Before calculating the ROI, the first step is to calculate the Relative Strength with the formula : RS = EMA(Nh) / EMA(Nb) with
The second step will allow us to calculate the ROI as follows : RSI = 100 - (100 / (1 + RS))
Note : it is possible to obtain various types of RSI depending on the moving average used (exponential, arithmetic, weighted...)
The result will be expressed as a percentage, which is extremely simple to interpret:
It is important to understand that between the change in the RSI and the change in the price of the asset, the RSI indicator will be given priority during a divergence. In other words, if the price of an asset is up but the RSI is down, this is a bearish divergence.
Caution : Traders are advised not to take a buy or sell until the 30 or 70 level is reached by the RSI oscillator.
However, when these thresholds are reached, it is possible for the investor to make two interpretations:
In order to reinforce the credibility of these hypotheses, it is sometimes possible to wait for a double divergence signal (involving the occurrence of two classical divergences in a row).
Good to know : to limit the risk when taking a position, it’s a good idea to filter the RSI divergence signals at the support and resistance zones.
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RSI divergence is adapted to the most active trader profiles, for whom the signals are less numerous but relatively clear. Thus, Scalping and even Day Trading are the trading strategies that lend themselves best to this practice. For Swing Trading (a strategy generally spread over several days), MACD divergence is preferred.
This tool has many advantages for the investor:
The limitations of RSI divergence are that this tool is ineffective in a market where the trend is too strong, since it will be more difficult to identify trend reversal points.
Moreover, this instrument is mainly aimed at both active and patient profiles: false signals are quick to happen, so it is preferable to couple RSI divergence with other longer term technical indicators such as historical volatility.
By providing investors with effective signals, RSI divergence offers security when taking positions in the financial markets. However, as with any indicator, it is preferable to take precautions by using complementary instruments as well as by positioning Stop Loss and Take Profit to limit your potential losses.