Mastering RSI: How to Identify Divergences and Trend Reversals in the Stock Market

The Relative Strength Index or RSI is one of the most reliable oscillators for detecting extreme market conditions. Beyond its popularity, the true power of this indicator lies in the divergences it can generate relative to the price, signaling with high probability trend reversals. However, like any technical tool, RSI works best when complemented with chart analysis and other momentum metrics.

RSI Fundamentals: What it is and how it works

The RSI (Relative Strength Index) belongs to the oscillator family and measures the momentum of bullish versus bearish closes over a specified period. This indicator stands out for two key features:

Volatility smoothing: Reduces erratic price fluctuations, generating more reliable signals.

Normalized range: Fluctuates between 0 and 100, allowing for objective identification of the price’s relative position.

The RSI formula

For n periods, RSI is calculated as:

RSIn = 100 - [100 / (1 + RSn)]

Where RSn represents relative strength:

RSn = Average of Bullish Closes / Average of Bearish Closes

The indicator compares the magnitude of bullish and bearish movements, normalizing this ratio on a fixed scale. It is generally parameterized with 14 periods, although this value can be adjusted according to your trading style.

Interpreting RSI signals: Overbought and oversold

The usefulness of RSI is maximized when it reaches extreme zones. Understanding its behavior is essential:

Overbought zone (RSI ≥ 70): An asset is considered overbought when the indicator exceeds this threshold. While it suggests a possible bearish correction, assets can remain in this condition for extended periods if there is ongoing demand at higher prices.

Oversold zone (RSI ≤ 30): Indicates a potential price rebound. However, if the asset’s fundamentals are weak, it may stay in this zone for a prolonged period as investors avoid buying.

The crucial mid-level (RSI = 50): This invisible level separates bullish from bearish behavior and helps validate trend continuation.

Practical case: Tesla between 2019 and 2022

Tesla (NASDAQ: TSLA)'s weekly chart illustrates how to interpret these zones:

In May 2019, RSI entered oversold territory. When it returned to the fluctuation band, the price formed higher lows, confirming an uptrend. Between June and December 2020, the indicator marked multiple highs in overbought zone (3 inflection points), but without falling into the mid-zone. This indicated corrections within a dominant bullish trend, representing opportunities to increase long positions.

The change manifested in October 2021: RSI reached overbought again, but with lower highs compared to previous occasions, while the price formed lower highs. This pattern break anticipated what would happen in December: the break of the previous uptrend. RSI fell into oversold territory, signaling that the trend had reversed.

RSI and price divergence: The most powerful signal

Divergence between RSI behavior and price is perhaps the most effective application of this indicator to anticipate reversals.

Bullish divergence: Buying opportunities

Occurs when the price makes lower lows within a downtrend, but RSI makes higher lows from the oversold zone. This decoupling indicates strengthening demand despite falling prices.

Example with Broadcom (NASDAQ: AVGO):

During a downtrend, the price continued making lower lows. Simultaneously, RSI was in oversold territory but made higher lows, revealing that buyers were gaining strength progressively. This RSI and price divergence correctly anticipated an upward reversal that remained valid months later.

Bearish divergence: Sell signals

Occurs when the price makes higher highs in an uptrend, but RSI makes lower highs from the overbought zone. This reflects a loss of momentum despite new price highs.

Case with Walt Disney (NYSE: DIS):

The price was forming progressively higher highs, suggesting continued bullishness. However, RSI was generating lower highs. This RSI and price divergence captured weakening momentum and preceded a sustained bearish reversal that lasted over a year.

RSI operational signals

Buy signal with RSI

To go long, three conditions must occur simultaneously:

1. RSI reaches oversold (below 30)
2. The indicator returns to the normal fluctuation band
3. The price breaks a previous downtrend line

The example of Taiwan Semiconductor Manufacturing (NYSE: TSM) between September and October 2022 clearly demonstrates this. With RSI in prolonged oversold territory, followed by recovery and finally breaking the long-term downtrend, long positions were validated.

Sell signal with RSI

For short operations, conditions are similar but inverted:

1. RSI reaches overbought (above 70)
2. The indicator retreats to the fluctuation band
3. The price breaks a previous uptrend line

Applied Materials Inc. (NASDAQ: AMAT) between November 2020 and April 2021 exemplifies this. After maintaining overbought conditions for months and developing a strong uptrend, RSI retreated while the price formed a lateral range. In January 2022, breaking the previous uptrend validated short positions.

Trend validation using the mid-level of RSI

An additional method uses the 50 level of RSI as a critical dividing line:

Oscillating between 50 and overbought: The price tends to rise, confirming an uptrend.

Oscillating between 50 and oversold: The price tends to fall, confirming a downtrend.

Meta Platforms (NASDAQ: META) from March 2020 exemplifies this principle perfectly. When RSI moved out of oversold territory and oscillated between 50 and the overbought zone, an uptrend was established. As long as the indicator’s corrections did not dip below 50, price declines represented retracements within the dominant trend.

Strengthening signals: RSI combined with MACD

Although RSI is robust, it occasionally generates false signals, especially on very short timeframes. Combining it with additional indicators improves reliability.

Integrated RSI-MACD system

The MACD (Moving Average Convergence Divergence) adds a second layer of confirmation:

1. RSI reaches overbought or oversold (necessary condition)
2. RSI returns to the fluctuation band
3. MACD line crosses the histogram’s midline in the opposite direction of the previous trend (sufficient condition)
4. MACD line crosses the SIGNAL line in the opposite direction to close the position

Block Inc. (NYSE: SQ) effectively demonstrated this combination. From an overbought position, with RSI declining and later MACD crossing below the histogram’s midline, a short position was validated. The position remained open until MACD crossed the SIGNAL line upward, which happened four months later in March 2022.

Practical conclusions

RSI and especially RSI-price divergence are powerful tools to increase probabilities in stock trading. However, they should never be used in isolation. Confirmation through previous trend breakouts and supplementation with indicators like MACD significantly strengthen any trading system. Patience in waiting for confluences of multiple signals, rather than rushing to trade, distinguishes consistently profitable traders from those who accumulate losses following false alerts.