RSI divergence : a clear signal for positioning on the markets

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.  

What is RSI Divergence ?

Divergence in Trading

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:

• that of the price of the asset
• that of a technical indicator.

Divergences are commonly used in markets such as :

• shares 
• CFDs
• stock market indexes
• cryptocurrencies
• FOREX (currency market)

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.  

Types of RSI divergence

Changes in RSI, coupled with changes in the price of the asset, can result in two types of divergence :

• Standard (or classic) divergence. This is the most common type of divergence and is characterized by contradictory trends, one of which becomes bullish when the other becomes bearish, and vice versa.
• Hidden divergence. This is more subtle: it describes similar movements in terms of general trend (bullish or bearish), but in this case the RSI and the asset price will not reach the same values.

Example of hidden divergence:

1. Both elements have the same upward trend.
2. The asset price reaches a first high, then a second lower high.
3. The RSI indicator, meanwhile, reaches a first high, then a second high.

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.  

How to trade RSI Divergence

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 

• EMA, i.e Exponential Moving Average
• Nh, i.e a specific number of bullish periods
• Nb, i.e the same number of bearish periods

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:

• if the RSI is above 50, it describes an upward trend
• if the RSI is below 50, it describes a downward trend
• if the RSI is 70, it is an overbought signal (bearish divergence)
• if the RSI is 30 level, it is an oversold signal (bullish divergence)

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:

• the loss of momentum leading to a corrective movement of the trend
• the end of a trend involving a reversal (or on the contrary a consolidation)

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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Why You Should Trade RSI Divergence

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:

• it offers a clear and precise signal
• it reduces the level of risk without affecting the potential benefits
• it is based on a trading system that favors quality over quantity
• it has its place in all types of financial markets

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.  

Conclusion

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.