Master RSI and divergence to anticipate market turns

The Relative Strength Index (RSI) holds a prominent place among technical oscillators for its ability to detect market extremes. But where it truly demonstrates its potential is when it generates divergences relative to the asset’s price, a signal that can precede significant trend changes. However, like any technical tool, the RSI works best when complemented with other analysis strategies.

Understanding RSI: Mechanical Fundamentals

The RSI, or Relative Strength Index, belongs to the category of momentum indicators. Essentially, it measures the ratio between bullish and bearish closes over a specified period, normalizing the result on a scale from 0 to 100. This architecture grants the indicator two specific operational advantages: first, it smooths out erratic volatility spikes, reducing noise; second, it provides a constant fluctuation band that facilitates the relative interpretation of the price position.

The calculation formula is:

RSI = 100 - [100 / (1 + RS)]

Where RS represents the average of bullish closes divided by the average of bearish closes over n periods (typically 14, but adjustable according to the trading horizon).

Practical Interpretation: Beyond 30 and 70

When RSI exceeds 70, the asset is considered to be in overbought territory. Counterintuitively, this does not guarantee an immediate decline; a price can remain at these levels for months if buying appetite remains strong. What matters is what happens when the indicator leaves this zone: it may be a correction within the previous uptrend, not necessarily the end of it.

Similarly, readings below 30 indicate overselling, suggesting potential for a rebound. But again, staying in this zone depends on fundamental factors; if an asset has weak fundamentals, the market can keep it depressed for extended periods.

A level often overlooked but crucial is the midpoint (50). This acts as a psychological boundary:

• When RSI oscillates between 50 and 70, the price tends to expand upward
• When it remains between 30 and 50, the price tends to contract downward
• As long as it does not break the middle level, we are looking at corrections or consolidations, not confirmed trend changes

Trading Signals with RSI

The most reliable signals require convergence of three elements. For buying:

• RSI reaches oversold (less than 30)
• It subsequently returns to the normal fluctuation band
• The price breaks a previous downtrend line

Take the case of Taiwan Semiconductor Manufacturing (NYSE: TSM). Between September and October 2022, the indicator remained in oversold territory. Subsequently, it rebounded as the price broke the downtrend that had been ongoing since January 2022. This was the entry point for long positions.

For selling, the pattern reverses:

• RSI reaches overbought (greater than 70)
• It retreats to the central band
• The price breaks an uptrend line

With Applied Materials Inc. (NASDAQ: AMAT), between November 2020 and April 2021, the indicator remained overbought with a strong bullish rally. From then on, it retreated while the price generated a sideways range. In January 2022, a downward break of the previous trend occurred, an ideal moment for short entries that proved profitable for months.

Divergence: When Price and Momentum Are Out of Sync

Divergence trading represents the most powerful phenomenon generated by RSI. It occurs when inflection points of the price move in the opposite direction of the indicator’s inflection points.

Bullish divergence: Develops within a downtrend when the price makes lower lows while RSI makes higher lows from its oversold zone. This misalignment anticipates a likely bullish reversal.

Broadcom (NASDAQ: AVGO) exemplifies this. During a bearish phase, the price continued forming lower lows, but RSI reflected progressively higher lows, indicating that selling pressure was waning. Indeed, a bullish trend followed that remained in effect for months afterward.

Bearish divergence: Occurs in uptrends when the price hits higher highs while RSI hits lower highs from its overbought zone. The oscillator detects loss of buying strength before it manifests in the price chart.

Walt Disney (NYSE: DIS) clearly showed this pattern. The price kept making higher highs suggesting continued bullishness. But simultaneously, RSI generated lower highs, revealing weakening momentum. The subsequent bearish reversal lasted over a year.

Strengthening: RSI-MACD Combination

RSI occasionally produces false signals, especially on very compressed timeframes. A tactic to increase reliability is to combine it with the MACD (Moving Average Convergence-Divergence), another momentum oscillator.

The operational protocol would be:

• Identify RSI in overbought or oversold conditions (necessary condition)
• RSI returns to the normal band
• MACD crosses its signal line in the opposite direction of the previous trend (sufficient condition for entry)
• MACD makes a new cross for position exit

Block Inc. (NYSE: SQ) illustrates this application. From an overbought condition in RSI, it gradually declined. MACD confirmed weakness when crossing downward its histogram’s midline. The short position was maintained until MACD crossed upward over its signal line, approximately 4 months later. Meanwhile, the downward movement continued to unfold.

Final Considerations

RSI and its divergences are valuable tools for traders seeking probabilistic advantages. However, no technical indicator should operate in isolation. Validation through previous trend lines, observing the indicator’s mid-level to distinguish corrections from reversals, and combining with other oscillators are practices that substantially increase success probabilities. The key is discipline in waiting for confluence of signals, not chasing every extreme reading generated by the indicator.