Forex trading involves many technical indicators and complex terms that can seem overwhelming at first. However, you don’t need to master all of them to become a successful trader. In fact, some indicators stand out for their effectiveness, and one of the most important is Relative Strength Index (RSI). This simple yet powerful tool can significantly improve your trading decisions and results. In this blog, we’ll take a closer look at RSI divergence: a popular strategy used by traders. We’ll explore its two main types, bullish divergence and bearish divergence, and share practical tips on how to use them effectively in your trading strategy.
What Is RSI Divergence?
To better understand RSI divergence, it’s helpful to first get familiar with the RSI indicator itself. When trading in the forex market, there are thousands of indicators designed to help you analyze charts more effectively and identify the best moments to enter or exit trades. One of the most widely used indicators is the RSI, which stands for Relative Strength Index.
RSI is a popular momentum oscillator that moves within a fixed range, usually between 0 and 100. It is commonly used to measure the strength of recent price movements and to spot potential overbought or oversold conditions in the market.
The RSI can be used in several ways depending on the trading scenario, and one of its most valuable applications is identifying RSI divergence.
However, RSI divergence is not the only use case of the RSI indicator. This tool comes with several other practical applications as well. Let’s learn about all of them below.
Spotting Trend Reversals Using RSI Divergence
RSI divergence is one of the key signals that can indicate a potential trend reversal when using the RSI indicator. A bullish RSI divergence suggests a strong possibility that the current downtrend may reverse into an uptrend, while a bearish divergence signals a likely reversal from an uptrend to a downtrend.
If this sounds a bit confusing or too technical, don’t worry! In the next section, we’ll break down both types of RSI divergence, bullish and bearish, in detail, along with real examples to help you understand how they work in practice.
Identifying Overbought and Oversold Conditions
Another common use case of the RSI indicator is identifying overbought and oversold conditions in the market.
As mentioned earlier, RSI moves within a range from 0 to 100. When the RSI value drops below 30, it indicates an oversold condition. This means that selling pressure may have peaked, and there is a higher chance that buyers will step in, potentially leading to a trend reversal from a downtrend to an uptrend.
On the other hand, when the RSI moves above 70, it signals an overbought condition. In this case, it suggests that buying pressure might be losing momentum, increasing the likelihood of a reversal from an uptrend to a downtrend.
Confirming Trend Strength
In addition to identifying RSI divergence, another useful application of the RSI indicator is confirming the strength of a trend. While RSI is commonly used to detect overbought and oversold conditions, it can also help traders validate whether a trend is likely to continue.
Here’s how it works:
- When the RSI stays consistently above 50, it indicates bullish momentum, suggesting that the uptrend is strong and likely to continue.
- When the RSI remains consistently below 50, it signals bearish momentum, pointing to a strong and ongoing downtrend.
By paying attention to how the RSI behaves around the 50 level, traders can gain more confidence in their trend analysis and make more informed trading decisions.
Types of RSI Divergence
In general, divergence occurs when two or more elements move in different directions or deviate from each other. In the context of forex trading and technical analysis, RSI divergence refers to a situation where the price of an asset or currency pair, such as EUR/USD, moves in the opposite direction of a technical indicator, in this case, the RSI.
This divergence between price and indicator often signals a potential trend reversal or a weakening of the current trend. Recognizing this can help traders anticipate market changes and adjust their strategies accordingly.
In the following section, we’ll dive into the two most common types of RSI divergence: bullish RSI divergence and bearish RSI divergence.
Bullish RSI Divergence
Both bullish and bearish divergences occur when the price of an asset and the RSI indicator move in opposite directions. However, when we talk about a bullish divergence, we’re referring to a situation where the price is making lower lows, while the RSI is forming higher lows.
This pattern suggests that although the price is still falling, the downward momentum is weakening. In other words, selling pressure is losing strength, and there is a strong potential for a trend reversal from a downtrend to an uptrend.
Let’s say the EUR/USD pair is in a downtrend. The price drops from 1.0800 to 1.0750, then bounces slightly before falling further to 1.0700. Meanwhile, the RSI reads 28 at the first low and 32 at the second, even though the price has dropped lower. This creates a bullish divergence: the price is making new lows, but RSI is rising, signaling that selling pressure is fading and a potential uptrend could begin.
Bearish RSI Divergence
On the other hand, bearish RSI divergence occurs when the price makes higher highs, but the RSI forms lower highs. This indicates that although the price is rising, the bullish momentum is weakening, suggesting a potential shift from an uptrend to a downtrend.
Just like bullish divergence, recognizing bearish divergence can help traders anticipate trend reversals.
Imagine the EUR/USD pair is in an uptrend. The price first rises to 1.0950, then pulls back slightly and climbs to a new high of 1.1000. However, during this same period, the RSI peaks at 68 on the first high and then drops to 60 on the second high. This creates a bearish divergence: the price is rising, but the RSI is falling, signaling that the buying pressure is weakening and a potential downtrend may follow.
How to Trade with RSI Divergence?
So far, we’ve covered the basics of the RSI indicator and how to spot RSI divergence. Now, let’s take it a step further and learn how to use RSI divergence to make smarter trading decisions and predict the forex market. Here’s a simple step-by-step guide to get started:
1. Find Key Support and Resistance Zones
Before using RSI signals, it’s important to first identify the overall trend and mark the key support and resistance levels. These zones highlight where buying or selling pressure is likely to increase, giving you a better sense of market dynamics.
2. Spot the Divergence
Once you’ve identified support and resistance areas, watch the price action closely and look for divergence between price movement and the RSI. This can signal a possible trend reversal.
- At resistance zones, keep an eye out for bearish divergence: a sign that selling pressure might be increasing and a downward move could be coming.
- At support zones, look for bullish divergence, which could signal rising buying pressure and a potential upward shift.
3. Set Your Entry and Execute the Trade
When you spot the divergence, confirm the signal with a price pattern. Your entry should be based on the type of divergence:
- For bearish divergence, look for bearish patterns like double tops, head and shoulders, or bearish candlestick patterns like the evening star or bearish engulfing.
For bullish divergence, watch for bullish patterns such as double bottoms, inverted head and shoulders, or candlestick patterns like the morning star or bullish engulfing.
You can read more about bearish and bullish patterns on our blog on Top 18 Bullish and Bearish Reversal Candlestick Patterns.
4. Place a Stop-Loss Order
To save your profits and prevent any losses, place a stop-loss just beyond the nearest support or resistance level. This helps limit your losses in case the market moves unexpectedly.
5. Set a Take-Profit Target
Don’t forget to set a take-profit order as well. It helps you lock in gains and manage your risk. Like your stop-loss, your take-profit level should be placed around the next major support or resistance zone, depending on the direction of your trade.
Real Example of Trading with RSI Divergence
By following the above steps, you can efficiently find suitable entry points and trade with the RSI indicator and RSI divergence.
Looking at the chart below, we can see that the overall trend was bearish until the price reached a key support level. At this point, while the price formed a lower low, the RSI showed a higher low, signaling a bullish divergence RSI.
This suggests that a potential bullish reversal could be underway, and the price might start to rise from the support level. Alongside the bullish divergence, a clear Falling Wedge pattern is also forming near the support zone.
The price has already shown signs of reversing, shifting from a downtrend to an uptrend. After breaking above the wedge’s upper trendline, the price pulled back briefly, which helps confirm the reversal.
- You can consider entering a short position after a strong bullish candle appears following the pullback.
- Set your take-profit near previous resistance levels or within consolidation zones.
- Place your stop-loss just below the recent swing low near the support area.
Top Tips on Trading with RSI Divergence
Forex market is full of unpredictable moments, and by just using one technical indicator, you can not guarantee your success. It’s highly recommended to use risk management techniques and protect your trades:
- Only risk 1–2% of your total account balance per trade. This helps protect your capital even during a losing streak.
- RSI can stay overbought or oversold for a while. Don’t open too many positions just because the RSI hits 70/30. Wait for confirmation from price action.
- Don’t trade all your positions on correlated pairs (like EUR/USD and GBP/USD). Spread your risk across different pairs with different behaviors.
- Place your stop-loss based on RSI signals and price action (e.g., just beyond recent support/resistance when RSI shows divergence). Never trade without a stop-loss.
Learn more tips by reading our article about top risk management techniques.
Conclusion: Is RSI Divergence Good for Trading?
All in all, using RSI divergence can help you spot potential trend reversals and gain better insight into where the market might be headed. The RSI indicator, especially when combined with divergence analysis, is widely used by traders to decide when to enter or exit a position.
That said, the forex market is never 100% predictable, so always remember to apply proper risk management strategies. You can incorporate RSI divergence into your trading plan alongside other technical tools to improve your overall results.
Stay tuned to the ITBFX blog for more trading strategies using RSI and other helpful indicators.
RSI divergence occurs when the price of assets moves in the opposite direction of the RSI, indicating a potential trend reversal.
The RSI 70/30 rule states that the RSI above 70 suggests an overbought market, while below 30 indicates an oversold market.
RSI divergence can be reliable, especially when you combine it with other indicators or price action analysis.
To confirm signals by RSI divergence, you can use various technical tools like trendlines, support/resistance levels, candlestick patterns, or additional indicators like MACD.
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