Last Updated on 7 September, 2021 by Samuelsson
RSI divergence is a very common signal used by traders to find opportunities in the markets. It is one of the most effective RSI signals used as a trade trigger. This signal occurs in different ways, and your ability to identify it in the right situation and take advantage of it determines how effectively you can trade with the RSI indicator.
In this post, we will explain what the RSI indicator is and discuss the various types of RSI divergence signals and how to trade them.
What is the RSI?
The RSI is a short form for the relative strength index, which is a technical indicator that oscillates between 0.00 and 100. It measures the magnitude of recent price changes to show the momentum of the price. Hence, it is considered a momentum oscillator. The indicator is present in most trading platforms.
The indicator shows overbought or oversold conditions in the price of an asset as it swings up and down within its indicator box. Traditionally, when the indicator is above the 70 level, the market is considered overbought, and when the indicator is below the 30 level, the market is considered oversold. However, traders can choose any level they want to indicate the overbought/oversold levels.
But more importantly, owing to the swinging nature of the indicator, it can give divergence signals when the indicator swings are not in phase with the price swings.
RSI divergence signal
Usually, the RSI indicator line swings up and down in sync with the price swings. However, there are times when the price movement and the indicator movement are not in phase. Then, we say there is a divergence.
The RSI divergence signal is generated when the price swings and the indicator movement are no longer in phase. It could be that the price is making a higher swing high when the indicator is making a lower high or the price is making a lower swing low when the indicator is making a higher swing low. There are other ways the price and the indicator can diverge.
What a divergence implies is that the price swing is losing momentum and is likely to reverse soon.
Types of RSI divergence and what they indicate
There are different ways to classify RSI divergence. They include the following:
- Classifying RSI divergence based on the type of price swing that forms it:
- Classical divergence: This type is formed when the price swing is making a lower swing low or a higher swing high.
- Hidden divergence: This type is formed when the price is making a higher swing low or a lower swing high.
- Classifying RSI divergence based on the type of signal it gives:
- Bullish divergence: This is an RSI divergence that gives a bullish reversal signal.
- Bearish divergence: This is an RSI divergence that gives a bearish reversal signal.
Combining both classifications, you will arrive at four types of RSI divergence:
- Classical bullish divergence
- Classical bearish divergence
- Hidden bullish divergence
- Hidden bearish divergence
Classical bullish divergence
The RSI forms this type of divergence occurs when it makes a higher low, while the price swing is making a lower low. This divergence mostly forms after a prolonged downtrend or a multi-legged pullback in an uptrend, and it indicates a bullish reversal signal.
Classical bearish divergence
The classical bearish divergence forms on the RSI when the price is making a higher swing high while the RSI is making a lower high. You may see this signal when the price has been in an uptrend for a long time or in a multi-legged price rally during a downtrend. Of course, it gives a bearish reversal signal.
Hidden bullish divergence
This type of divergence occurs when the price is making a higher swing low while the RSI is making a lower low. You often see this when there is a pullback in an uptrend. It gives a bullish reversal signal that indicates that the pullback is exhausted and the next impulse wave of the uptrend is about to begin.
Hidden bearish divergence
The hidden bearish divergence occurs when the price is making a lower high while the RSI is making a higher high. You often see this when there is a pullback (price rally) in a downtrend. It gives a bearish reversal signal that indicates that the pullback is exhausted and the next impulse wave of the uptrend is about to begin.
How to trade the RSI divergence signal
As a technical trader, you can use RSI divergence signals to formulate a swing trading strategy. The good thing about trading the price swings is that it doesn’t matter whether the market is trending or range-bound, you can use the RSI divergences to identify the beginning of a new swing and trade it.
To improve the success of your trades and take only high-probability trade setups, it is best to take price swings that start from a recognized support or resistance level. You enter a position when the price swing does not correspond with the RSI swing. So, there should be a confluence of a strong support/resistance level and an RSI divergence.
Here is how to identify an RSI divergence at the right place and enter a trade at the right time:
- Draw a trend line to indicate the current direction of the trend and if the market is range-bound, draw horizontal lines to show the support and resistance boundaries of the range.
- Observe the price swing highs and lows and compare the current price swing high or low with the one preceding it to know which is higher or lower.
- Attach your RSI indicator to the chart and identify the relevant peaks/troughs on the indicator that match the swing highs/lows on the price chart.
- Spot any divergence between the current price swing high/low and the RSI’s peak/trough.
- Confirm that the price current price swing is bouncing off a support/resistance level or a trend line
- Ascertain whether the signal is bullish or bearish so you can trade along
- Determine your entry point — this can be at the open of the next candlestick after the divergence is formed.
- Ensure you place your stop loss order some distance beyond that support or resistance level.
- Place your take-profit order at the next support/resistance level or use a 2:1 reward/risk ratio.