This week, I want to discuss the RSI Divergence Indicator study. It’s great for spotting divergence and adding to our Divergence Study Series. The last divergence study focused on volume by reviewing the On Balance Volume study, and this study will focus on price by reviewing the RSI Indicator.
Table of Contents
RSI Divergence Indicator Introduction
A bullish signal on the RSI indicator signals that the price did not move in sync with the RSI; the price moved low, but the RSI moved less. This bullish divergence is an indication of strengthening momentum. A bearish signal on the RSI indicator signals that the price and RSI are not in sync.
The price formed a higher move than the RSI. This bearish divergence is an indication of weak momentum. This week, I wanted to add to the Divergence Studies Collection by focusing on the RSI and the Divergent RSI as a trading signal and confirmation indicator.
While learning about the market and understanding the different indicators, the RSI divergence indicator showed me that even the greatest indicators have limitations. The simple fact is they are not perfect, and they all lag price action, but they do help paint a clearer picture.
Look Back & Forward Looking
There are TWO TYPES of market measurement regarding momentum studies, such as the RSI divergence indicator. As a result, the look-back indicators that measure previous data to offer the trader confirmed market bias.
The forward-looking indicators allow the trader to anticipate immediate or future market action. This is key when making trades—especially our favorite kinds of trades, successful ones.
Leading Indicators
The RSI divergence indicator is great for anticipating future market action in choppy or trending markets by offering signals that current market sentiment has reached extreme levels. This helps with spotting reversals, profit-taking, and more.
It allows the trader to analyze the market to anticipate a reversal or a trend change. This leading indicator leads price movements, anticipates price movements, and gives signals about approaching changes or reversals.
Wilder RSI
I wanted to use the RSI divergence indicator for everything when I first started using it. It was such a powerful tool with such great signals that I wanted to have it on every chart in every trade.
After a few losses, I took a second look at the RSI. Why would it offer such great signals on some trades and yet offer such bad signals on other trades? While researching, I came across the book Technical Analysis for the Trading Professional. It was written about J. Welles Wilder and the studies that he developed.
Check out the Bullish Bears trading service if you aren’t familiar with us. We do several live daily screen shares in our chat room and teach you the ins and outs of how to trade.
Trade With the Trend
The RSI divergence is a great tool when we use it for the right reasons. However, it fails if we do not respect and appreciate its limitations. Awareness is key!
First, a trader should trade with the trend in a trending market. Small pull-backs in a strong trending market are not signals to go short.
The RSI is constantly looking for the end of the trend. It’s always looking for failing momentum or a reversal, especially in the hot zones. If the market is strongly trending, you should not look for a reversal. Instead, it would be best to seek confirmation of a continuation.
Adjustment
Second, the RSI divergence is great for seeking market bottoms, tops, and divergence. However, if you want a tool for signaling pull-back entries, consolidation, or slight corrections in a trending market, perhaps something else would work better.
Put away the RSI and use something like the Stochastic for that signal or market analysis type. Or understand how to adjust the RSI for those kinds of signals. Why?
Because oscillators such as the RSI indicator only work well in range-bound or choppy markets. In the picture below, the arrows show when the trend changed by marking where RSI crossed the Extreme lines of 30 and 70. Pay attention to these hot zones.
Peaks: RSI Divergence
Without offering a change to the RSI “look-back” period (typically set at 14), the RSI is best used to watch market peaks, valleys, and divergence when trading short-term or intraday.
However, the RSI is very adaptable and has many useful assets for every type of trader who understands how to adjust it for their specific use.
For example, when buying a new vehicle, you might want to tune it or remove the restrictions to get a better performance that suits your needs. Stock indicators are very similar. Traders want to tune them to their preferences.
How to Adjust RSI Divergence Indicator
The Relative Strength Index (RSI) is a momentum (MOMO) indicator originally developed by J. Welles Wilder. The development of the RSI was to measure the magnitude of change in price action while offering signals of “overbought” or “oversold” conditions.
The average RSI setting is 14 periods, with 70 as overbought signals and 30 as oversold signals. A cross above 70 indicates that the ticker is primed for a correction, a pull-back, or a trend reversal. A cross below 30 indicates that the ticker is undervalued.
Adjusting RSI Divergence Indicator
The 70 / 30 setting offers a trader signals of extremes in price action. In a strong trending market, the RSI rarely falls below 40 and often sticks to the 50 – 80 range.
When the RSI crosses the 50 line, it signals a trend change. This is a greater warning than a simple extreme reading above or below the 70-30 lines and gives an earlier warning.
Average Price: RSI Divergence Indicator
When the indicator crosses the 50 line to the upside, the average buying price exceeds the average selling price over the period.
The opposite is true for a downside cross of the 50 line. These 50-line crossovers can signal a great time to enter a trade on the pull-back.
Signals: RSI Divergence
I added a 50 line to the RSI so that those signals are seen more easily. Then, I added an alert to the 50-line cross-over and the extreme cross-overs at 70 and 30.
I also added divergence dots to the RSI so that traders are alerted to Divergence with a dot on the RSI line, a dot on the overbought/oversold line, and a pop-up label.
Here is my modified RSI study with Divergence and Labels / Alerts: http://tos.mx/IwZYe1
How to Calculate RSI Divergence
- This is how RSI divergence is calculated:
- Pick the base number of periods on which to base the study. (Average Setting: 14).
- Compare today’s closing price with yesterday’s.
- (On intraday charts, this would be the current candle’s close with the previous candle’s close).
- Add all the upward movements in points between closing prices.
- Add all the downward movements between closing prices.
- The upward and downward price movements calculate the EMA (exponential moving average).
- Calculate the relative strength:
- RS = EMA Upward Price Movements /EMA Downward Price Movements.
- Calculate the Relative Strength Index (RSI): RSI = 1 / ( 1 + RS )
Teamwork
When using the RSI on an intraday timeline, these mathematical formulas change to calculate the ratio between each candle the same way.
A few indicators pair well with the RSI, and using them together can provide better trading signals. I am a trader who likes confirmation before pulling the trigger on a trade. What kind of trader are you? Do you think the RSI divergence indicator can help you?
Confirmation Analysis
Try to pair the RSI with another signal for confirmation. Try using one of these pairs.
A candlestick strategy is paired with RSI by reading candlestick formation, price structure, and support and resistance zones.
MACD strategy coupled with RSI by analyzing MACD signals of divergence and histogram crossovers. Find daily levels of support and resistance to maximize positive results.
RSI with MA Cross strategy by using the moving average lines as support and resistance signals, crossover signals, and trend confirmation.
Pair the Bollinger band strategy with RSI by analyzing over-extended price action and signal when prices are below/above market value. I like to use multi-time frame analysis of Bollinger bands using Trend Spider. You can read more about TrendSpider with our TrendSpider review (which also has multi-timeframe analysis for lower indicators)
Recap
Trade Lessons:
- Wait for confirmation before considering a trade.
- The RSI can remain in a strong trend at extreme levels for long periods.
- Don’t jump right in when you see a reading of 70; first, allow the RSI line to fall below the overbought line to at least give a stop loss level to trade-off. (Also called a Swing Failure – see below).
- Watch the 50 Line for trend confirmation.
- If the RSI line reaches an extreme and then returns to the 50 Line, it better indicates a turning point in the trend. Waiting for this to occur can reduce fake-outs!
- It is common for technical traders to watch the 50 Line to show shifts in trend.
- If the RSI is above 50, it is considered a bullish uptrend; if it’s below 50, it is considered a bearish downtrend.
Failure: RSI Divergence
RSI Failure Swing Trade is discussed in depth at StockCharts.com
- A ‘bearish failure swing‘ happens when the RSI enters the overbought zone at 70 and returns below the 70 mark again.
- In this case, a short position will be entered only after the RSI cuts down through the 70 line from the top.
- The ‘bullish failure swing’ occurs when the RSI enters the oversold zone at 30, then rallies again, and rises above the 30-line again.
- The trader uses this rise above the 30 line as a trigger to go long.
Labels
I added a 50-line crossover alert and pop-up labels to identify when divergence has happened. Combined with the RSI Divergence Dots on the RSI Line and Divergence Signals on the Overbought and Oversold lines, this indicator has four ways to communicate that divergence has occurred.
Final Thoughts: RSI Divergence Indicator
I added a 50-line crossover alert and pop-up labels to identify when the RSI divergence has happened. Combined with the RSI Divergence Dots on the RSI Line and Divergence Signals on the Overbought and Oversold lines, this indicator has four ways to communicate that Divergence has occurred.
The RSI indicator is a great tool when used correctly. The RSI’s greatest ability is finding divergence and identifying market tops/market bottoms. But your ability to recognize price action, trends, volume, and sentiment will help you put the whole thing together and maximize the effectiveness of any tool or indicator. Experience needs to be acquired. You won’t get there overnight, but stick at it. It’s a marathon, not a sprint race.
Take some time to become familiar with the RSI, which will be a great addition to your market analysis toolkit. Before you know it, you’ll be scalping stocks, making new highs of day in no time!
Frequently Asked Questions
The RSI divergence indicator should be set to 70/30 so find strong trends.
The one-hour chart or longer is the best timeframe for the RSI divergence indicator.
The MACD is better for showing trend reversals. The RSI is better for showing overbought/oversold areas.
The RSI is very reliable at showing overbought and oversold areas.
