What Is RSI Divergence and How Do You Identify It?

The Relative Strength Index (RSI) is a widely used momentum oscillator in technical analysis, providing insights into the speed and change of price movements for a financial asset. The primary purpose of the RSI is to identify potential overbought or oversold conditions within the market. When the price of an asset moves in one direction while its corresponding indicator moves in the opposite direction, this discrepancy is known as “divergence” in technical analysis. This phenomenon can signal a potential shift in market dynamics.

Fundamentals of RSI and Divergence

The Relative Strength Index (RSI) measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of an asset. This indicator is typically displayed as a line graph that oscillates between zero and 100. Conventional thresholds for the RSI are 70 and 30, where a reading of 70 or above suggests an overbought condition, and a reading of 30 or below indicates an oversold condition.

Divergence in technical analysis occurs when the price of an asset moves in a direction opposite to that of a technical indicator, such as the RSI. This discrepancy suggests that the momentum supporting the current price trend may be weakening or changing. For example, if an asset’s price reaches higher highs, but the RSI simultaneously registers lower highs, it indicates a divergence.

Types of RSI Divergence

RSI divergence can manifest in four primary forms. These types are categorized into “regular” divergence, which typically signals a potential trend reversal, and “hidden” divergence, which often suggests a continuation of the existing trend.

Regular bullish divergence occurs when an asset’s price forms lower lows, yet the RSI simultaneously registers higher lows. This pattern suggests that despite the falling price, the downward momentum is weakening, indicating a potential reversal to the upside. It often appears at the end of a downtrend, hinting that selling pressure is diminishing.

Conversely, regular bearish divergence appears when the price makes higher highs, but the RSI forms lower highs. This indicates that while the price is rising, the bullish momentum is fading, signaling a potential reversal to the downside. This type of divergence is typically observed during an uptrend.

Hidden bullish divergence is identified when the price makes higher lows, but the RSI shows lower lows. This pattern suggests a continuation of an uptrend, implying that despite a minor pullback in price, the underlying bullish momentum remains strong. It serves as a signal that the market is likely to continue its upward movement.

Finally, hidden bearish divergence occurs when the price forms lower highs, while the RSI makes higher highs. This suggests that the current downtrend is likely to continue, indicating that even with temporary upward movements in price, the overall bearish momentum persists. This pattern often appears during a downtrend, reinforcing the prevailing direction.

Identifying RSI Divergence

Identifying RSI divergence involves a systematic approach of comparing price action with the corresponding movements of the RSI indicator on a chart. The process begins by observing significant price swings, specifically focusing on consecutive highs or lows in the asset’s price. Simultaneously, attention should be paid to the corresponding high or low points on the RSI indicator, which is typically plotted below the price chart.

To confirm the presence of divergence, one can draw trendlines on both the price chart and the RSI indicator. For instance, to identify a regular bearish divergence, a trendline would connect two higher highs on the price chart, while a separate trendline would connect two corresponding lower highs on the RSI. Similarly, for a regular bullish divergence, a trendline would connect two lower lows on the price chart, and another would connect two corresponding higher lows on the RSI.

Interpreting RSI Divergence Signals

The presence of RSI divergence provides technical analysts with an indication of potential shifts in market momentum. Regular divergence, whether bullish or bearish, suggests that the current price trend may be losing strength and could be headed for a reversal. A regular bullish divergence, for example, indicates that selling pressure is weakening, potentially foreshadowing an upward price movement. Conversely, a regular bearish divergence implies that buying momentum is fading, signaling a possible downward reversal.

Hidden divergence, on the other hand, typically suggests a continuation of the existing trend after a temporary pause or pullback. Hidden bullish divergence indicates that an uptrend is likely to resume, while hidden bearish divergence suggests a downtrend will continue. It is important to understand that RSI divergence acts as a warning signal, suggesting that the momentum behind the current trend is weakening or shifting. These signals do not guarantee a definitive price movement, but rather highlight a potential change in market dynamics.