Understanding RSI Divergence
Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and 100. Traditionally, and according to J. Welles Wilder, its inventor, RSI is considered overbought when above 70 and oversold when below 30. Divergences form on the RSI indicator when the RSI trend differs from the price trend. Identifying RSI divergence can be an invaluable skill for traders looking to spot potential reversals or confirm trend continuations.
Types of RSI Divergence
Before diving into how to identify RSI divergence, it’s important to understand the types of divergence we look for.
Bullish Divergence
This occurs when the price records a lower low, but the RSI forms a higher low. This indicates that despite the decrease in price, the downside momentum is weakening. A bullish divergence often precedes a trend reversal to the upside.
Bearish Divergence
Conversely, a bearish divergence forms when the price hits a higher high, but the RSI records a lower high. This suggests that while the price is climbing, the upward momentum is starting to decrease. A bearish divergence can signal a forthcoming downtrend.
Step-By-Step Guide to Identifying RSI Divergence
Identifying RSI divergence involves several steps, from setting up your chart to interpreting what you see. Let’s break down the process.
Step 1: Choose Your Chart
Start with a price chart of the asset you are analyzing. It’s best to use candlestick charts as they provide more information about price movements within a specific timeframe. Ensure the RSI indicator is applied to your chart, typically below the main price chart.
Step 2: Observe the Price Trend
Look for the overall trend in the price. Are you seeing higher highs and lows (uptrend), or lower highs and lows (downtrend)? Identifying the prevailing price trend is crucial before you look for divergences.
Step 3: Compare Price Movements to the RSI
Once you’ve identified the price trend, check if the RSI mirrors the price movements. Remember, a divergence occurs when the price trend and the RSI trend do not match.
Step 4: Identify the Type of Divergence
Based on your observations, determine if you’re seeing a bullish or bearish divergence. Remember, a bullish divergence occurs in downtrends when the price hits lower lows, but the RSI hits higher lows. Bearish divergence is the opposite and occurs in uptrends.
Step 5: Confirmation
Identifying a divergence does not guarantee a reversal. Look for additional confirmation through other technical indicators or chart patterns. For instance, a bullish divergence followed by a rising trend line break might confirm a trend reversal to the upside.
Conclusion
Identifying RSI divergence is a powerful technique for traders aiming to catch potential trend reversals early. However, it’s essential to remember that no indicator is foolproof. Combining RSI divergence with other aspects of technical analysis can increase your chances of making successful trades. Always remember to manage your risk and consider using stop-loss orders to protect your investments.
