Introduction to RSI Divergence
The Relative Strength Index (RSI) is a popular tool among traders and analysts, used to identify potential price reversals in financial markets. One of the key techniques used with the RSI is identifying divergences, which can often signal a potential change in the prevailing trend. This article will explore the concept of RSI divergence, how to identify it, and its implications for trading.
Understanding RSI
Before diving into RSI divergence, it’s crucial to understand what the RSI is. The Relative Strength Index is a momentum oscillator that measures the speed and change of price movements. Developed by J. Welles Wilder, the RSI is calculated using the average gains and losses of an asset over a specified period, typically 14 periods.
The RSI ranges from 0 to 100. A reading above 70 is typically considered overbought, indicating that the asset may be primed for a price drop. Conversely, a reading below 30 is considered oversold, suggesting that the asset may be due for a price rise.
What is RSI Divergence?
RSI divergence occurs when the price of an asset and the RSI indicator move in opposite directions. There are two types of RSI divergence: bullish and bearish.
Bullish RSI Divergence
A bullish RSI divergence occurs when the price of an asset makes a new low, but the RSI makes a higher low. This divergence suggests that the downward trend is losing momentum and a bullish reversal could be in the offing.
Bearish RSI Divergence
A bearish RSI divergence, on the other hand, happens when the price of an asset makes a new high, but the RSI makes a lower high. This divergence indicates that the upward trend is losing steam and a bearish reversal could be imminent.
Identifying RSI Divergence
Identifying RSI divergence involves carefully observing the price movement of an asset and the corresponding movement of the RSI. Here are the steps:
Step 1: Plot the RSI
The first step in identifying RSI divergence is to plot the RSI on your chart. Most trading platforms have the RSI indicator built-in.
Step 2: Identify Peaks and Troughs
Next, identify the peaks and troughs in both the price and the RSI. Look for new highs and lows in the price and see if the RSI is making corresponding highs and lows.
Step 3: Look for Divergence
Finally, look for divergence between the price and the RSI. If the price is making new highs but the RSI isn’t, or if the price is making new lows but the RSI isn’t, you’ve identified an RSI divergence.
Implications for Trading
RSI divergences can be powerful signals for traders. A bullish RSI divergence could be a signal to buy, while a bearish RSI divergence could be a signal to sell. However, like all trading signals, RSI divergences should be used in conjunction with other technical analysis tools and not relied upon in isolation. Always consider the overall market context and use stop losses to manage your risk.
