RSI: How to master this technical indicator and divergence strategy

The RSI Index is probably one of the most reliable oscillators for detecting extreme conditions in the market. Divergence trading using this indicator appears as one of the most effective signals to anticipate trend changes with greater certainty. However, like any technical tool, RSI does not work alone: it should be complemented with trend analysis and other indicators to improve the likelihood of success.

Understanding the Relative Strength Index

The Relative Strength Index (RSI in its acronym in English) is an oscillator that measures the magnitude of bullish movements versus bearish movements over a specified period. What makes it special is its ability to smooth out extreme price variations and express the results on a fixed scale between 0 and 100, allowing quick identification of the asset’s relative position.

The RSI uses a mathematical formula that compares the average of bullish closes with the average of bearish closes. By default, it is set to 14 periods, although this parameter can be adjusted according to your trading strategy.

The two main features of RSI

(1) Noise reduction: The indicator filters out erratic price fluctuations, providing cleaner and more reliable readings.

(2) Normalized scale (0-100): This constant fluctuation band allows easy comparison of different assets and timeframes.

Correct interpretation of the Relative Strength Index

Overbought and oversold

When the RSI rises above 70, it is considered that the asset is in an overbought situation. This suggests that the price could retreat, but it is important to note that assets with strong bullish trends can remain in this zone for extended periods if buying appetite remains high.

When RSI falls below 30, we are in an oversold situation that could signal a bullish rebound. However, if the fundamentals of the asset are weak, it may continue to fall even from these extreme conditions.

The mid-level: an invisible ally

The 50 level of the RSI is crucial to validate the persistence of a trend. When the indicator oscillates between 50 and 70, the price tends to continue its upward movement. Conversely, when it fluctuates between 50 and 30, it suggests a consolidated downtrend. As long as RSI does not cross the mid-level, the corrections observed are temporary and the main trend remains intact.

Case studies: From theoretical analysis to practice

Tesla: An example of multiple phases

Throughout 2019-2022, Tesla experienced several distinguishable phases with RSI. During May 2019, the indicator hit the oversold zone, anticipating a rebound that indeed occurred. Between June and December 2020, RSI made three consecutive highs in the overbought zone, but the price never deviated significantly, indicating normal corrections within a dominant bullish trend.

The real change came in October 2021. This time, RSI failed to reach the previous overbought zone again, while the price was making lower highs. The bullish trend break occurred in December, confirmed by an RSI drop into oversold territory. From that moment, the dynamics changed: as long as the indicator fluctuated between oversold and the mid-level, short positions maintained the advantage.

Meta Platforms: Validating trends with the 50 level

In 2020, Meta (formerly Facebook) showed a similar pattern. After hitting oversold in March 2020, RSI remained oscillating between the 50 level and the overbought zone for months, confirming that the bullish trend was consolidating. Each correction was contained within the mid-level, allowing traders to add positions on each retracement.

The change came in February 2022. When RSI crossed below the 50 level after remaining above it for so long, the signal was clear: the down cycle was starting. As observed afterward, Meta continued to fall in the following months, with RSI staying below 50, confirming the new market reality.

Buy and sell signals with RSI

Basic buy signal

The buying opportunity occurs when three conditions are met simultaneously:

1. The RSI reaches the oversold zone (below 30)
2. The indicator moves back toward the fluctuation mid-zone
3. The price breaks a previous downtrend line

Taiwan Semiconductor Manufacturing provided a clear example between September and October 2022. RSI was in oversold territory for weeks, then started to recover. When the price finally broke the downtrend line from January 2022, that was the ideal entry point for long positions.

Basic sell signal

Sales follow the inverse logic:

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

Applied Materials between November 2020 and April 2021 showed RSI persistently in overbought while the price continued rising. The indicator declined but without compromising the trend. However, in January 2022, after months of lateral price consolidation, the downward break occurred and RSI confirmed with a move downward. Traders who waited for the break of the previous trend achieved better results than those who sold prematurely.

Divergence trading: The most powerful RSI signal

When the high and low points of the price align with those of the RSI, the current momentum is confirmed. But when they diverge, one of the most reliable signals of an imminent change in direction appears.

Bullish divergence: Lower lows, higher indicator

This pattern occurs within a downtrend. The price continues falling, marking lower lows, but the RSI begins to make higher lows. This indicates that, although the price is decreasing, selling pressure is diminishing and demand is recovering ground.

Broadcom provided a clear example of bullish divergence. While the price was falling within its downtrend, RSI started showing relatively higher highs in the oversold zone. This disconnect anticipated the trend change that actually occurred days later.

Bearish divergence: Higher highs, lower indicator

This pattern emerges during uptrends. The price continues reaching higher highs, but the RSI makes progressively lower highs. It is a clear warning that the bullish momentum is waning.

Walt Disney was a textbook case of bearish divergence. In 2021, while the price kept making higher highs, RSI could not match that strength, marking increasingly lower highs from the overbought zone. About a year later, the bearish correction that the indicator anticipated materialized.

Strengthening your signals: Combining RSI with MACD

The RSI can generate false signals, especially on very short timeframes. A strategy to reduce this risk is to combine it with another oscillator like MACD.

MACD has three components: the MACD line, the SIGNAL line, and the Histogram. The conditions to open a trade are:

1. RSI reaches overbought or oversold (necessary condition)
2. RSI returns to the fluctuation band
3. The MACD line crosses the zero level of the histogram in the opposite direction of the previous trend (sufficient condition)

To close the trade:

• The MACD line crosses the SIGNAL line in the opposite direction

Block Inc. in 2021-2022 demonstrated the effectiveness of this combination. From an overbought situation in RSI, the indicator declined while MACD confirmed with a bearish crossover over the zero level. The resulting short position remained profitable for four months until the bullish crossover of MACD over the SIGNAL line signaled the close.

Conclusion

The RSI and the divergence trading it generates relative to the price are powerful tools that significantly increase the probability of success in market operations. However, remember that no indicator works in isolation. Validation through trend analysis and combining with other indicators is what turns these technical signals into reliable trading decisions.