This week I want to discuss the RSI Divergence Indicator study. It’s that’s great for spotting divergence and add to our Divergence Study Series. In fact, the last divergence study focused on volume by reviewing the On Balance Volume study and this study will focus on price by reviewing the RSI Indicator.
Table of Contents
How to Use RSI Divergence Indicator When Trading
A bullish signal on the RSI indicator signals that price did not move in sync with the RSI; price moved low, but the RSI moved less. This bullish divergence is an indication of strengthening momentum. A bearish signal on the RSI indicator signals that price and RSI are not in sync.
The price formed a higher move than the RSI. This bearish divergence is an indication of weak momentum. This week I wanted to add to the Divergence Studies Collection by focusing on the RSI and the Divergent RSI as a trading signal and confirmation indicator. In fact, there is one particular reason for choosing the RSI study as my next project; discussing why indicators are chosen and when to use them.
When I was learning the market and developing an understanding of the different indicators, the RSI Study showed me that even the greatest indicators have limitations. The simple fact is they are not perfect, and they all lag price action, but they do help paint a clearer picture.
In a trending market the RSI can signal when the trend has ended
Look Back & Forward Looking
There are TWO TYPES of market measurement when it comes to momentum studies. As a result, the look-back indicators that measure previous data to offer the trader confirmed market bias. The forward-looking indicators that are used to give the trader an opportunity to anticipate immediate or future market action. This is key when making trades. Especially our favorite kind of trades, successful ones.
Moving Average Cross-Over Gives Signal AFTER the Trend is Established
Leading Indicators
The RSI is a great indicator for anticipating future market action in choppy or trending markets by offering signals that current market sentiment has reached extreme levels. This helps with spotting reversals, profit taking and more.
It offers the trader an opportunity to perform analysis on the market in an attempt to anticipate a reversal or a trend change. This leading indicator leads price movements, anticipates price movements, and gives signals about approaching changes or reversals.
RSI Gives Trend Signal much sooner than the MA
Wilder RSI
When I first started using the RSI divergence I wanted to use it for everything. It was such a powerful tool with such great signals that I wanted to have it on every chart in every trade.
After a few losses I took a second look at the RSI. Why would it offer such great signals on some trades and yet offer such bad signals on other trades? While performing my research I came across the book Technical Analysis for the Trading Professional. It was written about J. Welles Wilder and the studies that he developed.
Check out the Bullish Bears trading service if you aren’t familiar with us. We do several live daily screen shares in our chat rooms, and teach you the ins and outs of how to trade.
RSI Signals Range Bound Markets
Trade With the Trend
The RSI divergence is a great tool when we use it for the right reasons. However, it’s a failure if we do not respect and appreciate the limitations that it has. Awareness is key!
First things first; in a trending market a trader should trade with the trend. Small pull-backs in a strong trending market are not signals to go short.
The RSI is constantly looking for the end of the trend. It’s always looking for failing momentum or a reversal. Especially in the hot zones. If the market is strongly trending you should not look for a reversal. Instead you should be looking for confirmation of a continuation.
Adjustment
Second, the RSI divergence is great for seeking market bottoms, market tops, and divergence. However, if you want a tool for signaling pull-back entries, consolidation, or slight corrections in a trending market then perhaps something else would work better.
For that type of signal or type of market analysis put away the RSI and use something like the Stochastic. Or understand how to adjust the RSI for those kinds of signals. Why?
Because oscillators such as the RSI indicator only work well in range bound or choppy markets. In the picture below, the arrows show when trend changed by marking where RSI crossed the Extreme lines of 30 and 70. Pay attention to these hot zones.
Peaks: RSI Divergence
Without offering a change to the RSI “look-back” period (typically set at 14); the RSI is best used to watch market peaks and valleys and market divergence when trading short term or intraday.
However, the RSI is very adaptable and has many useful assets for every type of trader who understands how to adjust it for their specific use. Just like buying a new vehicle, you might want to tune it, or remove the restrictions to get better performance to suit your needs. Stock indicators are very similar. Traders want to tune them to their preference.
Undersatnding when to adjust the RSI can offer new uses and strategies
How to Adjust RSI Divergence Indicator
The Relative Strength Index (RSI) is a momentum (MOMO) indicator originally developed by J. Welles Wilder. The development of the RSI was to measure the magnitude of change in price action while offering signals of “overbought” or “oversold”conditions.
The average RSI setting is 14 periods; with 70 as overbought signals and 30 as oversold signals. A cross above 70 indicates that the ticker is primed for a correction, a pull-back, or a trend reversal. A cross below 30 indicates that the ticker is undervalued.
Adjusting RSI Divergence Indicator
The 70 / 30 setting offers a trader signals of extremes in price action. In a strong trending market the RSI rarely falls below 40, and often sticks to the 50 – 80 range.
When the RSI crosses the 50 line it signals that a trend change has happened. This is a greater warning than a simple extreme reading above or below the 70-30 lines and gives an earlier warning.
Average Price: RSI Divergence Indicator
When the indicator crosses the 50 line to the upside, it means that the average buying price is greater than the average selling price over the period.
The opposite is true for a downside cross of the 50 line. These 50-line crossovers can signal a great time to enter a trade on the pull-back.
RSI Signals Range Bound Markets
Signals: RSI Divergence
I took the time to add a 50 line to the RSI so that those signals are seen more easily. Then I added an alert to the 50 line cross-over as well as adding alerts to the extreme cross-overs at 70 and 30.
I also added divergence dots to the RSI so that traders are alerted to Divergence with a dot on the RSI line, a dot on the overbought / oversold line, with a pop-up label.
Here is the my modified RSI study with Divergence and Labels / Alerts: http://tos.mx/IwZYe1
How to Calculate RSI Divergence
- This is how rsi divergence is calculated:
- Pick the base number of periods on which to base the study.(Average Setting: 14).
- Compare today’s closing price with yesterdays.
- (On intraday charts this would be the close of the current candle with the close of the previous candle).
- Add all the upward movements in points between closing prices.
- Add all the downwards movements between closing prices.
- The EMA (exponential moving average) is calculated by the upward and downward price movements.
- Calculate the relative strength:
- RS = EMA Upward Price Movements /EMA Downward Price Movements.
- Calculate the Relative Strength Index (RSI): RSI = 1 / ( 1 + RS )
Teamwork
When using the RSI on an intraday timeline, these mathematical formulas change to calculate the ratio between each candle the same way.
There are a few indicators that pair well with the RSI and using them together can proved better trading signals. I am a trader that likes confirmation before pulling the trigger on a trade. What kind of trader are you? Do you think the RSI divergence indicator can help you?
Confirmation Analysis
Try to pair the RSI with another signal for confirmation. Try using one of these pairs.
A candlestick strategy paired with RSI by reading candlestick formation, price structure, support and resistance zones.
MACD strategy coupled with RSI by performing analysis on MACD signals of divergence and histogram crossovers. Find daily levels of support and resistance to maximize positive results.
RSI with MA Cross strategy by using the moving average lines as signals of support and resistance, as crossover signals, and as confirmation of trend.
Pair the bollinger band strategy with RSI by performing analysis to spot over-extended price action and signal when prices are below / above market value. I like to use multi-time frame analysis of bollinger bands using Trend Spider. You can read more about TrendSpider with our TrendSpider review, (which also has multi-time frame analysis for lower indicators)
Recap
Trade Lessons:
1. Wait for conformation before considering a trade.
2. The RSI can remain at extreme levels for long periods in a strong trend.
3. Don’t jump right in when you see a reading of 70, first allow the RSI line to fall back below the overbought line to at least give a stop loss level to trade off. (Also called a Swing Failure – see below).
4. Watch the 50 Line for trend confirmation.
5. If the RSI line reaches an extreme and then returns to the 50 Line it is a better indication of a turning point in the trend. Waiting for this to occur can reduce fake-outs!
6. It is common for technical traders to watch the 50 Line to show shifts in trend.
7. If the RSI is above 50, then it is considered a bullish uptrend and if its below 50 then it is considered a bearish downtrend.
Failure: RSI Divergence
RSI Failure Swing Trade is discussed in depth at StockCharts.com
1. A ‘bearish failure swing’ happens when the RSI enters the overbought zone at 70 and then comes back down below the 70 mark again.
2. In this case, a short position will be entered only after the RSI cuts down through the 70 line from the top.
3. The ‘bullish failure swing’ occurs when the RSI enters the oversold zone at 30 and then rallies out again and rises above the 30 line again.
4. The trader uses this rise above the 30 line as a trigger to go long.
Two ways to display Divergence: On the RSI Line or on the Overbought / Oversold Line
Turn off RSI Divergence and the signal will only Show on the Overbought / Oversold Line
Pop up labels will also appear to confirm Divergence
Labels
I added a 50 line crossover alert and pop up labels to identify when divergence has happened. When combined with the RSI Divergence Dots on the RSI Line and Divergence Signals on the Overbought and Oversold lines, this indicator has 4 ways to communicate that Divergence has taken place.
New settings to turn off or change where the divergence signals appear
Final Thoughts: RSI Divergence
I added a 50 line crossover alert and pop up labels to identify when the RSI divergence has happened. When combined with the RSI Divergence Dots on the RSI Line and Divergence Signals on the Overbought and Oversold lines, this indicator has 4 ways to communicate that Divergence has taken place.
The RSI indicator is a great tool when used correctly. Finding divergence and identifying market tops / market bottoms is the RSI’s greatest ability. But your ability to recognize price action, trends, volume, and sentiment is going to help you put the whole thing together and maximize the effectiveness of any tool or indicator. Experience is needs to be acquired. You won’t get there overnight, but stick at it. It’s a marathon, not a sprint race.
Take some time to become familiar with the RSI and it will be a great addition to your market analysis toolkit. Before you know it you’ll be scalping stocks making new highs of day in no time!
