Divergence Trading and RSI: Complete Guide to Identifying Breakpoints in the Markets

Trading divergence is perhaps one of the most powerful concepts in technical analysis when working with oscillators. The RSI indicator, in particular, offers early signals that can completely change our perspective on market direction. However, understanding how these divergences work first requires mastering the fundamentals of the RSI itself.

What is RSI really in the markets?

The Relative Strength Index (Relative Strength Index) belongs to the family of oscillators, those indicators that help us measure price momentum. Unlike other indicators that follow the trend, RSI attempts to anticipate changes in direction by comparing the magnitude of bullish movements against bearish movements over a specified period.

Its two main features make it especially useful:

• Volatility smoothing: Reduces erratic price jumps, providing a clearer reading of underlying momentum
• Standardized scale: Always fluctuates between 0 and 100, making interpretation and comparison between different assets easier

The mathematical formula behind it normalizes the ratio between the average bullish and bearish closes, allowing for consistent analysis regardless of the asset being traded.

The mechanics behind the indicator: Overbought and oversold

When RSI exceeds 70, we say the market is overbought. This does not automatically mean the price will fall, but indicates that buyers have dominated for several periods. The reality is more nuanced: an asset can remain overbought for weeks if the bullish trend is strong enough and investors are willing to pay higher prices.

The interesting part occurs when the indicator leaves this extreme zone. It could mean:

• A temporary correction within the bullish trend (additional entry opportunity)
• The start of a significant reversal (exit signal)

The key is to validate this with trend analysis on the price chart.

Conversely, when RSI drops below 30, we are in oversold territory. Again, this does not guarantee an immediate recovery. If the fundamentals of the asset are weak, it could remain under pressure for a long time. But when it finally leaves this extreme zone, the trend context will tell us whether it’s a rebound or the beginning of a sustained reversal.

The mid-level (50): The invisible boundary of momentum

There is a level many traders overlook: 50. Mentally dividing the fluctuation band into two halves provides a powerful filter:

• When RSI oscillates between 50 and 70, prices tend to maintain an upward trajectory. Drops toward the 50 level represent corrections within a consolidated bullish trend
• When RSI oscillates between 30 and 50, prices usually maintain a downward direction. Rebounds up to the 50 level are just corrections in a dominant bearish trend

This mid-level acts as a “gas tank” for movement. If momentum isn’t strong enough to keep the oscillator above 50 during an uptrend (or below during a downtrend), it’s a sign that the direction is weakening.

Case study: Tesla and trend transitions

Let’s observe how RSI behaved in Tesla’s stock between 2019 and 2022. In May 2019, the indicator fell into oversold territory while the price was clearly declining since January. It was a potential entry point for patient bullish traders.

The price started forming higher lows from that moment, developing a clear uptrend line. RSI confirmed this momentum by rising into overbought territory in February 2020. Despite the COVID-19 pandemic, when the indicator retreated toward the middle zone, the price did not break its previous uptrend. That was not the end, but a temporary correction.

This behavior repeated between June and December 2020, with RSI making multiple highs in overbought territory but not falling significantly into oversold. This confirmed that corrections were mild and the uptrend remained strong.

The crucial change came in October 2021. For the first time, RSI failed to reach the overbought zone with the same vigor. Simultaneously, the price began forming lower highs. This was the bearish divergence signaling what was to come: in December 2021, the price broke its previous uptrend and RSI plummeted into oversold territory. The trend had shifted.

Meta Platforms: Trend validation through the 50 level

Meta Platforms’ stock provides an excellent example of how the 50 level of RSI validates trend continuation or breakouts.

In March 2020, the indicator touched oversold territory, preceding a clear rebound in price. Once RSI left that extreme zone and fluctuated between 50 and 70 (70), the price developed a clear consolidated uptrend. As long as RSI stayed above 50, any decline was interpreted as a correction, not a trend end.

However, between June, July, and August 2021, multiple overbought peaks appeared. The inevitable question was: when would this bullish trend end? The answer came in February 2022 when the price broke its previous trendline and RSI headed back toward oversold territory. But the crucial point was that after this downward move, RSI failed to stay above 50 consistently. That indicated the previous uptrend no longer controlled the market; now a bearish consolidation was dominating.

Trading signals with RSI: Beyond extremes

Basic RSI use requires three simultaneous conditions to generate reliable signals:

For a long entry:

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

Let’s take Taiwan Semiconductor Manufacturing (TSM) as an example. Between September and October 2022, RSI was clearly in oversold territory. But simply reaching this zone was not enough. We had to wait for the indicator to recover and, simultaneously, for the price to break the downtrend line from January 2022. Only then was it prudent to open long positions.

For a short entry:

1. RSI reaches overbought territory (above 70)
2. The indicator returns to its normal band
3. The price breaks its previous uptrend line

Applied Materials Inc. followed this pattern between 2020 and 2022. RSI spent months in overbought territory, but that was just confirmation that the uptrend was very strong. Only when it finally retreated to the middle band and, more importantly, the price broke its previous uptrend (in January 2022), was it prudent to establish short positions. Confirming a trend break is more important than any oscillator extreme.

The true power: RSI divergence trading

This is where RSI shows its true value. A divergence occurs when the inflection points (maxima and minima) of the price move in the opposite direction of the RSI inflection points. These separations are powerful messages about imminent trend changes.

Bullish divergence: When the price falls but momentum rises

Imagine a clear downtrend. The price makes lower lows, but simultaneously, RSI begins making higher lows while remaining in oversold territory.

This was the case with Broadcom (AVGO) during part of 2022. The price kept falling, but selling pressure was decreasing. Demand was quietly gaining strength. RSI was signaling: “Although the price is still falling, the direction is about to change.” And indeed, weeks later, a clear bullish reversal occurred that lasted for months.

Bearish divergence: When the price rises but momentum falls

The opposite scenario. During an uptrend, the price makes higher highs, but RSI makes lower highs while remaining in overbought territory.

Walt Disney displayed this pattern clearly between 2020 and 2021. The price kept breaking previous highs, suggesting the uptrend continued. But RSI was sending a different warning: with each new high in price, the indicator failed to reach new highs itself. The market was losing momentum despite the price still rising. Months later, the bearish reversal was confirmed and remained in effect for over a year.

Trading divergence is the most powerful tool any technical analyst must master. It’s not that RSI predicts the future, but that it anticipates the exhaustion of current momentum.

Operational robustness: Combining RSI with other oscillators

Like any tool, RSI has limitations. It can generate false signals, especially on very short timeframes. That’s why it makes sense to combine it with another momentum indicator to strengthen our decision system.

RSI and MACD: A confirmation approach

MACD (Moving Average Convergence Divergence) adds a second layer of validation. While RSI tells us “the market is reaching an extreme,” MACD tells us “and the direction is about to change.”

Operational conditions when combining both would be:

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

Let’s look at Block Inc. (SQ) as an example. In 2021-2022, RSI reached overbought territory after a clear uptrend. This was the necessary condition. Then, RSI started retreating toward the middle band, suggesting momentum loss. But the final confirmation came when MACD crossed below the histogram’s centerline, indicating the trend was about to turn downward. A short position was opened. The trade was maintained until MACD crossed back above its SIGNAL line, which happened about four months later.

The beauty of this combined system is that we don’t rely on a single indicator. RSI provides the extreme context, MACD provides confirmation of trend change. Together, they create a more solid decision.

Final thoughts

RSI is a versatile oscillator that offers multiple layers of information depending on how we interpret it. From obvious extremes of overbought and oversold, through the mid-level as a trend validator, to divergences as reversals anticipators, the indicator has analytical breadth.

But the most important lesson is that no technical indicator, no matter how powerful, replaces real trend analysis on the chart. Oscillators are necessary conditions, but validation through trend line breakouts is the sufficient condition to make operational decisions with a higher probability of success.

Trading divergence and RSI, when used within a broader analysis framework that includes trend validation and possibly confirmation from other indicators, become formidable tools for traders seeking to anticipate significant movements in financial markets.