RSI (Relative Strength Index) is one of the most popular and powerful indicators. It’s a momentum indicator. Often traders use it in the wrong way. They just take put trade when the RSI indicator touches the overbought zone and take call trade when the RSI indicator shows oversold. But this is not the right way to use it. Sometimes it works. Sometimes it’s not. Sometimes what happens is the indicator touches the overbought zone but the price still going an uptrend and vice versa. The best way to use RSI is RSI divergence.
In this article, we will discuss what is RSI indicator. How to use it. What are the best settings of RSI? How to trade perfectly with RSI divergence. RSI divergence types, RSI divergence with other sure shot confirmations. So let’s jump into it.
What is RSI?
RSI (Relative Strength Index) is a momentum indicator that is used in technical analysis. RSI measures the speed and momentum of assets or currencies.
The RSI is displayed as an oscillator like a line graph in the chart. It has a value of 0 to 100. Whatever the price is or it goes. The price movement roams around the 0 to 100 line.
When the price goes below the 30 line. It is considered as an oversold zone and the price may go up. On the other hand when the price goes up to 70 lines. Then it is considered an overbought zone and the price may fall from that point.
The calculation of the RSI indicator is dividing the average of positive prices by changes in the average of negative prices. Obtaining RSI by subtracting 100/(1+RS) from 100.
What Is RSI Divergence?
RSI divergence is one of the popular strategies in Forex, crypto, and stocks. This strategy is so powerful that In some cases, the price reverses Exactly from that RSI divergence point.
RSI divergence is the change between the price and the indicator. As you know RSI is a momentum indicator and it moves exactly how the price moves. But not always. There we got this strategy. When the price movement can not make equal highs or lows relative to the RSI line. Then it is a sign of reversal. RSI divergence is a both reversal and continuation strategy.
What Are The Settings For the RSI Divergence Strategy?
The default RSI setting is 14 period and the oversold zone and bought zone is 30,70. This is not the perfect setting for a perfect RSI divergence. Change the RSI period to 28 from 14. 14-period RSI makes the chart messy and may give a lot of false signals. Moreover, 28 period RSI gives us more information about data. That’s why changed the setting to 28.
Change the oversold value to 20 and overbought to 80. Sometimes the RSI line goes to 70 value and still goes up. And so as oversold. That’s why change the overbought and oversold value to get more accurate results.
Why RSI Divergence Is So Powerful?
RSI divergence strategy is so powerful because of several reasons. First of all, it is a momentum indicator. That’s why it moves according to price movement. When the price moves in a direction. For example, if the price makes a new higher high but the RSI line fails to make a higher high. That means the price makes a new high. But the RSI can’t. What’s the reason behind this? Because the buyers are getting weaker. The buying pressure is getting low. That is why the RSI shows a lower momentum. And it indicates to us that it may be the point of reversal. and that’s why it failed to make a new high. If you can use it properly you can become a successful trader.
How To Use RSI Divergence Strategy
There are two types of divergence strategies.
1. Regular Divergence Strategy
2. Hidden Divergence Strategy
1. Regular Divergence Strategy
Regular divergence is a reversal trading strategy. There are two types of regular divergence strategies.
Regular Bullish Divergence
In a regular bullish strategy if the market is in a downtrend. It creates continuous lower lows and lower highs. So as the RSI indicator. But when the indicator makes a higher low instead of a lower low. That’s an indication of regular bullish divergence. The logic behind regular bullish divergence is the seller’s exhaustion and buyer entry. It’s a bullish reversal strategy. So you have to take a long position when you see a bullish regular divergence.
For more confirmation, you have to take trades when the price is below the 20 value of RSI. If the divergence forms below the 20-period area. Then take a long position. We are taking a trade with double confirmation. First of all the divergence one. And the second one is the oversold zone. Two confirmations tell us about the exhaustion of the seller. The momentum of the seller is getting weak. That’s why we take a long position. There are other confirmations also.
Regular Bearish Divergence
Regular bearish divergence is totally the opposite of bullish divergence. It’s a bearish reversal strategy. When the market forms a new higher low and higher high. As usual, the RSI indicator also has to form a new higher low and higher high. And it usually happens. But when the RSI indicator fails to make a new higher high. Then it’s a sign of regular bearish divergence. Instead of making a new higher high, the RSI indicator makes a lower high pattern.
The pattern shows us that the buyers are not interested in taking the market upward. That’s why the RSI oscillator can’t make a new higher high. It’s a sign of buyer exhaustion. For more confirmation, you have to look at this divergence in the RSI overbought zone which is above 70 value. It gives us double confirmation. Then take a short trade with regular bearish divergence.
2. Hidden Divergence Strategy
There is an old saying in trading that. Trend is your friend until it bends. If you follow the trend and trade with the trend then you will be profitable unless it bends. The hidden divergence strategy is perfect for this saying. Because the hidden divergence strategy is a continuation strategy. Traders often trade with regular divergence. But hidden divergence is a high-accuracy strategy. But you need a little bit of practice and experience to identify this.
Hidden Bullish Divergence
Hidden bullish divergence is a bullish continuation strategy. This can be seen when the market is in an uptrend. When the price makes a new higher high and higher low. But instead of this, the RSI indicator makes a lower low. This is the sign of hidden bullish divergence. After a bullish divergence, it tells us that the trend will continue to uptrend.
For more confirmation, you will take the trades on an uptrend and oversold zone. If the trend starts from an oversold zone. It’s a sign of bullish momentum. Secondly, a bullish hidden divergence confirms the trend. It’s a highly promising setup but rare to find in the chart.
Hidden Bearish Divergence
Hidden bearish divergence is a bearish continuation strategy. You have to look for this strategy on a downtrend with the overbought zone. In this strategy, the price action makes a lower low and lower high. But the RSI indicator shows us a higher high instead of a lower low and it confirms the downtrend.
Though it’s a very good strategy you can not find the setup on every chart. Try using different charts and different time frames.
Confirmations Of RSI Divergence
1. Combine candlestick pattern with RSI divergence. When the indicator shows the divergence. Wait for another confirmation. If there is an engulfing candle in the divergence zone. Then it
confirms the reversal. In a bullish trend, it must be a morning star candlestick pattern, and for a downtrend, it has to be an evening star candlestick pattern.
2. If you want more confirmation. Use more momentum indicators like RSI. MACD, CCI, and money flow index (MFI) indicators with it. If all of them show the same divergence or most of them show the same divergence as RSI does. Then it confirms that the divergence is legit.
3. The divergence strategy is based on a specific swing high to swing low. If the swings are getting bigger. Then the possibility of divergence is getting lower. Because there are a lot of small divergences happening in the swing. That’s why the swing is getting weak. Always look for a small swing. Choose a swing that has not more than 20 candles. The swing that has less than 20 candles has a high possibility of reversal if there happens any divergence.
Final Words
Remember no strategy is 100 percent. To become profitable in trading you have to do money management and risk management. Without risk management, if you win even 100 trades consecutively, you will lose all your money in the 101st number of trades. So money management and risk management are important. Use a good risk-reward ratio. There are a lot of pro traders whose win ratio is less than 50% and they are still profitable. This happens because of the risk-reward ratio.
Consistency is the key. Cause it’s a long-term game. To sustain long term in the game you need a reliable, trustable broker. A broker who gives all facilities like instant payout, 24/7 customer response, low spreads, and security. The best broker in the market now is EXness, FBS, and M4Markets. If you want to start your journey of trading choose one of them.