In an earlier post- Unlocking RSI: A Trader's guide to smarter signals we talked about the fundamentals of RSI and the ways RSI can be used to make profitable trades. In that post, you learned about the meaning of RSI, the interpretation of RSI, and the basics of the utility of RSI in making profitable trades. In this post, I will discuss one particular facet of RSI- The RSI divergences and how to trade divergences in detail.
In this daily chart of UPL, you can see that the stock was in a downtrend initially and the stock price and RSI were falling together. Then between mid-February and mid-March, the stock made a lower low but the RSI failed to make a lower low, rather made a higher low as depicted in the chart through black trend lines. This is RSI divergence.
The chart above is a daily chart of Vedant Fashion. Notice that the stock was in a downtrend and made a lower low but RSI made a higher low during Mar-April 2024, which is a bullish RSI divergence. Also, notice that the trend reversed to an uptrend after the divergence.
In this daily chart of SBI, you will notice that the stock was in an uptrend and made a higher high during Nov- Dec 2022 but RSI made a lower high which is a bearish RSI divergence. Also, notice that afterward, stock prices started falling marking the trend reversal to a downtrend.
In this daily chart of Vedant Fashion, notice that the stock makes a bullish RSI divergence. The nearest swing high has been marked as the nearest resistance level with a blue line. Notice the entry point when the price closes above this resistance level. At the point of entry, the RSI is above 50 and the MACD line is above the signal line. Stop loss has been placed below the recent swing low.
What is RSI divergence?
Cambridge Dictionary defines the term "Divergence" as- The situation in which two things become different.
Talking in stock market parlance, divergence would then mean a situation in which price and some indicator move in opposite directions, that is to say, they have become different.
Taking it a step further, RSI divergence thus means a situation when the price moves in one direction and RSI doesn't follow suit and moves in another direction. So, RSI divergence is basically a discord between RSI and price. For example, suppose a stock makes a lower low and the RSI makes a higher low then there is a disagreement between the two and we will say that there is an RSI divergence.
Let us understand this through a chart.
In this daily chart of UPL, you can see that the stock was in a downtrend initially and the stock price and RSI were falling together. Then between mid-February and mid-March, the stock made a lower low but the RSI failed to make a lower low, rather made a higher low as depicted in the chart through black trend lines. This is RSI divergence.
Why does RSI divergence happen?
Now you might wonder why an RSI divergence occurs and why it is so important for traders. RSI is a momentum indicator which means it measures the speed with which prices are moving. A disagreement between RSI and price or RSI divergence means that the existing trend is losing momentum and trend reversal might be on the horizon.
This is why it is so important for traders. By spotting an RSI divergence traders can position themselves for the next trend and make big profits riding the trend. You can see in the chart above that after RSI divergence the trend reverses from a downtrend to an uptrend and by positioning yourself for a trade based on divergence you would have made a profit.
What are the types of RSI divergence?
RSI divergences can be categorized into two parts-
1) Bullish RSI divergence- A bullish RSI divergence occurs at the end of a downtrend. In a bullish divergence, price makes a lower low but the RSI fails to make a lower low and makes a higher low instead. This signals that the prevailing downtrend is about to end and stock might go into an uptrend.
The chart that we posted above is an example of a bullish RSI divergence. Here we have another example of a bullish RSI divergence.
2) Bearish RSI divergence- Bearish RSI divergence occurs towards the end of an uptrend when the price makes a higher high but the RSI fails to make a higher high and makes a lower high instead. Bearish divergence indicates that the prevailing uptrend is losing momentum and the trend might reverse to a downtrend. Take a look at the chart below-
In this daily chart of SBI, you will notice that the stock was in an uptrend and made a higher high during Nov- Dec 2022 but RSI made a lower high which is a bearish RSI divergence. Also, notice that afterward, stock prices started falling marking the trend reversal to a downtrend.
Now that you have a fair idea about RSI divergence let me ask you a question. What would you do once you have spotted an RSI divergence? Will you enter the trade right away? Or, will you wait for signals from other indicators before entering a trade? What should be your stop loss once you have entered a trade? And when will you exit the trade once it is in your favour? Well, the answers to these questions will make the next section of this article which would be the most important part of this article..
How to trade RSI divergences?
While RSI divergence is a strong trend reversal signal there are instances when there are what we call 'failed RSI divergences'. This means the trend doesn't reverse even after an RSI divergence. So, it is not advisable to enter a trade merely after spotting an RSI divergence rather you should wait for other parameters to fall in sync with the divergence before you enter a trade.
When to enter a trade after spotting an RSI divergence? Once you have spotted an RSI divergence mark the nearest resistance level (for a bullish RSI divergence). You should enter a trade once the price closes above the nearest resistance level.
Additionally, watch the RSI level when the price breaks the resistance. Enter only when RSI is above 50. RSI above 50 is indicative of good momentum on the upside. Another indicator that you should be watching is MACD. MACD line above the signal line suggests you can enter the trade.
The stop loss should be placed just below the recent swing low.
Let's understand this with an example.
Similarly, in case of a bearish RSI divergence, mark the nearest support level and enter a short trade when the price closes below the support level, the RSI is below 50, and the MACD line is below the signal line.
Let's understand this with an example.
In the above chart of SBI, notice the trade entry point after the price closes below the nearest support line. Notice that simultaneously the RSI is below 50 and the MACD line is below the signal line.
For exit make use of trailing stop loss that would let you ride the trend as long as the prices go in your favour thereby maximizing your profits.
I hope that you would have found this post enlightening. Spotting and trading RSI divergences let you ride the trend fully thereby maximizing your profits from a single trade. Though I have explained the concept of RSI divergence on a daily chart you can apply it at any timeframe. Happy trading !!
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