Readers who have been following my weekly outlook for a while, know that I often talk about RSI divergence. It is one of the tools in my trading toolbox. But what exactly is a divergence and how do you correctly identify it? How do you use the RSI indicator in reversal trading and how does it help you spot reversal setups?
I get a lot of questions about the details of how to use the RSI indicator in general and RSI divergence in specific, so let’s go over everything you need to know in order to use RSI divergences like a pro.
What is RSI?
Now, to understand RSI divergences, the first step is to know what the RSI indicator actually measures. Most of you will have seen it on your trading platform, but do you really understand what it does? Let’s have a look.
RSI stands for Relative Strength Index. It’s a momentum indicator, which means that it measures the speed (or strength) of the movement of a price. More specifically, it compares the magnitude of recent gains and losses over a specific time period. That time period is usually configurable and you’ll see that a popular period is 14, meaning that it will use the last 14 candles in the calculation. This doesn’t mean that the 14-period RSI is the best! A good exercise is to use different period settings and see the effect of them on the indicator.
The result is a value that indicates the speed and change of movements of the price. In other words, if a security has been increasing in value much more than it has been decreasing in value (i.e. it’s going up), the RSI indicator will also go up. Conversely, if the security has been decreasing in value more than it has been increasing in value (i.e. it’s going down), the RSI indicator will go down as well.
All of this is normalised to a scale of 0 to 100. So if the RSI indicator is closer to the lower end (let’s say 20), this means that the price has been in a downtrend for a while now and is probably in the oversold area. However, if the RSI indicator measures closer to the higher end (for example 80), it signifies that the price has been in an uptrend for a while and is in the overbought area.
For completeness, I’ll include the formula to calculate the RSI, although I believe it’s much more important that you understand the above explanation. There is only one parameter that is configurable, which is the period (the number of candles to go back). This is the formula:
RSI = 100 – 100 / (1 + ratio)
Where ratio equals the average gain of up periods / average loss of down periods. Let’s say that for a 14-period RSI, the average gain of the up periods is 40 and the average loss of down periods is 14, then:
RSI(14) = 100 – 100 / (1 + 40/14) ≈ 74
The result approximates 74. This means that the price is close to being overbought, which makes sense if we see that the average gain period was 40 and the average loss period was only 14. This price is going up!
Traditional use of RSI
Now, I’m willing to bet that the first time you’ve heard about RSI is something like this:
- If the RSI indicator is greater than 70, the price is overbought and you should sell.
- If the RSI indicator is below 30, the price is oversold and you should buy.
Right. Except that the price can keep going up, long after the RSI indicator showed a value larger than 70. And the price can keep going down for a long time after the RSI measured a value lower than 30. Simply put, RSI overbought and oversold regions are not reliable signals to go long or short.
In the example above, when the RSI indicator gave us a buy signal because the value was in the oversold region, the price was going up a little bit before moving down again. Then, when we got a sell signal because the RSI indicator showed values in the overbought region, the price kept on going up.
It might give you an indication, but it’s by no means precise enough to actually act on. I’ve coded many automated strategies based on the RSI indicator and they pretty much all perform very poorly on their own. A much better approach is to use the RSI indicator as a setup filter, with the actual buy or sell trigger being something else. But just by itself, this doesn’t work.
But what about that other way to use the RSI indicator?
Finally, we’re getting to the meat and bones of this article! Step one: what does it mean? An RSI divergence is when the price makes higher highs in an uptrend and the RSI indicator makes lower highs. Or in the other direction: when the price makes lower lows in a downtrend and the RSI indicator makes higher lows. Here’s an example to make it clear:
Here, we can see that the price is in an uptrend. In the beginning of the uptrend, the RSI indicator and the price are very similar; both are going up. At some point, however, the price will still make higher highs, but the RSI indicator is starting to go down and makes lower highs. That’s the divergence we’re looking for. In a downtrend, we see the exact opposite:
In this example, the price is in a downtrend. The price is making lower lows but all of a sudden, the RSI indicator shows us something: instead of making lower lows as well, we can see that the RSI indicator shows us higher lows. That’s RSI divergence.
Why Is This Useful?
Now, before I want to go any further, I want to talk about why this is significant. You might think: “ok, got it, an RSI divergence is when the price is going one way and the RSI indicator goes another way. But what’s the use?”.
Remember that the RSI indicator is a momentum or strength indicator. As long as the price and the RSI indicator line up, we can say that the current trend or price move is showing momentum in a specific direction. But once we see the price and the RSI indicator diverge, this momentum is fading. RSI divergence indicates that the current trend is losing strength!
If you recall how the RSI indicator is calculated, you will see that with an RSI divergence, the ratio of average gains vs average losses is starting to shift. In other words: RSI divergence shows us that the current trend is losing momentum and the conditions are setting up for a trend reversal. These are the early stages of a momentum shift, and that’s exactly what we’re looking for as reversal traders!
How To Draw RSI Divergences
There are a couple of things you need to keep in mind when drawing divergences. You might have noticed that during an uptrend, we connect the highs (and not the lows!) in order to detect a divergence. At the same time, we connect the highs and not the lows of the RSI indicator. On the other hand, if we are in a downtrend, we need to connect the lows (not the highs) of a price trend and the lows of the RSI indicator as well.
The way we draw divergences is thus a bit different from how we would usually draw a trend line on a price chart. In that case, you would likely connect the higher lows of an uptrend and the lower highs of a downtrend. We do this in order to see when the price would break the trend line, but in the case of RSI divergences, we do exactly the opposite!
Wicks or Bodies
Another question I often get is if we should use the wicks or the bodies of candles when drawing the trendline connecting the highs or lows. This is a question that requires a bit more nuanced answer, as there isn’t a single best one. The best advice I can give you is to use what makes sense. Let me explain.
Most of the times when the price makes higher highs, both the wicks and the bodies of the candles will make higher highs as well. There are definitely times where this isn’t the case, but often you can still see the direction of the trend.
It’s also a matter of picking the trendline that “works” the best. You will sometimes see that the wicks line up so perfectly on a trendline that it makes sense to use the wicks. In other cases (like the one above), it looks like a combination of wicks and bodies works the best. If you’re drawing trendlines, you should be looking for the trendline that makes the most connections to price points.
When we look at the example above, we can see that the upper trendline connects with the price on at least 6 different places. The lower trendline, on the other hand, only connects 2 wicks + one that overshot the trendline by a wide margin. So which one do you prefer? In the end, it’s a matter of common sense and seeing what works best.
Another question I get a lot is that if one of the trendlines is basically horizontal, does it still count as a divergence?
The short answer is: yes. The slightly longer answer is that basically, you should always look at both of the trendlines (on the price and on the RSI indicator). A divergence, in my opinion, happens from the moment that the direction of the two trendlines isn’t the same anymore.
In the above case, we can see that the price is in a very strong uptrend with a steep trendline. On the other hand, the RSI indicator is just flat. I would expect that if the momentum is still going strong, I would see a strong uptrend on the RSI indicator as well! This was the case for the price swings preceding this flattening phase, but it’s not like this anymore. As far as I am concerned, this is also a valid RSI divergence.
How To Use RSI Divergences
Finally, I’d like to take a moment to talk about how you can incorporate RSI divergences in the way you trade. For me, there are two main uses of RSI divergences, both relating to momentum exhaustion:
- It’s an early clue that a trend reversal might happen soon
- It’s a good way to see if the trend you’re in is losing steam and you should take profits on your position
What I said before about the “traditional” use of RSI also applies here, though: an RSI divergence on its own is not a strong enough signal to enter a trade. So the way I use RSI divergences is as one of the tools to build a convincing picture of a reversal setup.
If a reversal setup shows RSI divergence, together with a 200% Fibonacci extension, together with a head and shoulders chart pattern AND starts to show momentum in the opposite direction, THAT’s when I get interested.
However, RSI divergences are still very valuable since they are leading indicators of trend reversals, meaning that even before a reversal setup has developed, we will often see RSI divergences. It’s a good way to anticipate that a certain trend might develop into a reversal soon:
Of course, this won’t always happen, but I have found the RSI divergence to be one of the most valuable tools in my trading toolbox.
RSI divergences indicate that the current trend is losing strength.
But RSI divergences are also no magic formula. However, if used correctly, it can provide you with valuable information about the momentum of the current trend and the possibility of a future trend reversal. It’s especially interesting for reversal traders and early trend traders since a lot of their trading strategy revolve around correctly detecting a shift in trend direction.
I would recommend to anyone that is interested in using RSI divergences to have a play with it and try to draw the correct trendlines, keeping in mind the remarks I mentioned in this article. If you find a divergence, keep track of the price and find out if the trend was indeed losing momentum and potentially changing direction.
As always, if you have any questions about RSI divergences or trading in general, don’t hesitate to contact me!