Using divergence is a popular way to identify potential trading opportunities. But how does it work and when does it stop working?
RSI Divergence occurs when the Relative Strength Index indicator starts reversing before price does. A bearish divergence consists of an overbought RSI reading, followed by lower high on RSI. At the same time, price must make a higher high on the second peak, where the RSI is lower. In a bullish divergence situation, there must be an oversold condition on the RSI, followed by a higher low on the RSI graph. Simultaneously, price must form a lower low on the second peak.
Now let's take a closer look at some examples of RSI divergence and how you can use it to identify potentially profitable trading opportunties.
What is RSI Divergence?
Another way to look at RSI divergence is that RSI can show a change in price momentum, before you see a change in price action. You can think of it as an early warning signal.
In other words, it helps traders spot potential price reversals.
RSI Divergence Examples
It can be tough to visualize divergence from words alone, so now let's take a look at few charts, so you can see divergence in action. I'll give you examples of both bearish and bullish divergence.
Bearish Divergence
Here's an example of bearish divergence. Price finds 2 new highs, but on the RSI, there are 2 new lows. This can give you a hint that upward momentum is slowing down and a downward move could be coming soon.
One thing to notice about this example is that there are 2 divergence signals here. You might have traded the first divergence and possibly been stopped out. If you didn't take the second divergence, then you would have been stuck with a loss.
So it can help to re-enter a trade if your basic analysis of the trade stays the same.
Bullish Divergence
As you would expect, bullish divergence is just the opposite of bearish divergence.
First look for an oversold signal on the RSI indicator.
Next, look for a lower low in price action and a higher low in RSI. The higher low in the RSI does not have to be in the oversold area for the signal to be valid.
Here's an example of bullish divergence on the AUDCHF.
How Do You Confirm RSI Divergence?
The first thing to understand is that you cannot “confirm” any trading signal, in a way that would guarantee a profitable outcome.
You probably understand that, but some new traders think that there's a way to always be sure of a winning trade.
That's simply not possible.
Trading is about wins and losses.
However, you should do everything you can to verify that you have a legitimate divergence trading signal…before taking a trade.
Luckily, there are only a few variables that go into a valid divergence signal.
The first thing to look for in RSI divergence is a situation where RSI is in an overbought or oversold condition. This shows that there is a relatively extreme move and price is likely to bounce back from that level.
Then look for a situation after that where:
- Oversold: Price forms a lower low, but RSI forms a higher low
- Overbought: Price forms a higher high, but RSI forms a lower high
Also remember that the candle has to close for it to be a true RSI divergence signal.
Do not take trades before the candle closes and you get a verified divergence.
In order to take advantage of as many divergence signals as possible, it helps to have a RSI alert indicator. It's installed on a desktop or laptop and can send an alert via: email, text message (where available) and/or push notification via the mobile app.
What are the Settings for RSI Divergence?
Just like with any other indicator based trading strategy, the specific settings for the RSI indicator will vary between traders. However, the best place to start is with the default RSI settings:
- 14 period
- 30/70 signal levels
Divergence Trading Strategy Optimization
Now that you understand what RSI divergence is, let's take a look at a few ways to optimize a divergence trading strategy. These methods can help you increase your win rate or average profit per trade.
Use Support and Resistance
You can increase your odds of winning by looking for support and resistance levels that coincide with RSI divergence.
The key is to look for a very clear support/resistance level.
This is what a good signal looks like. Notice how far back you would have had to look back to identify the support level.
Trailing Exit
Another way to maximize your profits on a RSI Divergence trade is to trail your stop loss.
Like with any other trading method, changing your exit method does have trade-offs. When you start using a trailing exit, your win rate will probably go down.
On the bright side however, trailing your stop loss can increase your overall profits and you can potentially automate your exits.
As the saying goes:
Cut your profits short and let your profits run.
How do you trail your stop loss?
There are many ways to do this, but I'll give you 2 examples.
One popular method is to use the Parabolic SAR indicator. It prints dots above or below every candle.
In this example of a long trade, you could trail your stop loss at one or two PSAR levels back from the current candle.
If you don't like the rigidity of the PSAR indicator, another way to trail your stop is to move it to the next support or resistance level.
For example, here's a chart where there was a RSI divergence and the market started to trend.
By trailing your stop loss at each blue line, you would have been able to lock in profits as price moved in your favor. This move would have made much more profit, compared to simply targeting 1R or the next support level.
Fixed Profit Targets
If you don't like the uncertainty of trailing profit targets, or targeting support/resistance levels, then fixed profit targets could be right for you.
A good place to start with fixed targets is to simply set take profit orders at risk multiple levels.
For example you could start with 1X risk, or 1R, as a profit target. So if your stop loss was at 100 pips, you could set your take profit at 100 pips.
If you want to automate your “R” trailing stop, you can get our Risk Multiple Trailing Stop EA for MetaTrader 4. It will manage your trailing stop automatically, according to the amount of risk you took on the trade.
This method is especially helpful if you find that you are frequently right about a price move, but then price retraces against you and you either get stopped out, or price hits breakeven.
Different charting platforms have different ways that you can mark off multiples of risk. My favorite way is to use TradingView's Risk/Reward tool.
Here's how the tool works.
Another way to do it is to use the Fibonacci tool on any charting platform. The tool can be repurposed to show to the multiples of risk on any trade you're looking for.
Since you can add multiple levels to the Fibonacci tool, it can show you 1R, 2R…10R, etc.
This video will show you how to do it in MetaTrader.
When Does RSI Divergence Fail?
Just like any other trading methodology, divergence will not work 100% of the time.
The most common instance when divergence fails, is in strongly trending markets. If you take too many divergence trades in a strong trend, you will lose a lot of money.
So be sure to have a solid money management plan in place.
Here's an example:
Learn to identify when you're in a trend and have something like a 2-strikes rule, to cut your losses short.
Your win rate and percent return will also be determined by your exit strategy, the quality of your execution, and your ability to objectively analyze your results.
The most common reasons for the failure of any trading system are:
- Not enough testing
- Giving up too early
- Not journaling your trades properly
- The strategy doesn't have an edge
- Unrealistic expectations
- Not knowing your expected statistics
- Missing good trading opportunities
Those are issues primarily related to your trading psychology and trading process. Therefore, if you have a trading strategy that has an edge and you're on a losing streak, then you need to look at your process and psychology.
Don't switch systems just because you have a losing streak. It might not be an issue with your strategy.
Take an objective look at all elements of your trading.
Conclusion
So that's how RSI divergence works.
You may also be wondering how hidden RSI divergence works. That's a totally different animal, so I'll cover that in a future tutorial.
But for now, if RSI divergence appeals to you, then work on solidifying a real trading strategy.
Remember that although divergence may look good in a few well-chosen examples, you need to have a complete, well-tested trading strategy in order to have long-term success with RSI divergence.
This starts with creating a trading plan and backtesting your plan. Then if your strategy passes those tests, you can move into beta testing…and if that works out, then to live trading.
Take the time to go through this process.
If you rush into live trading, you'll just end up on the Trading Silodrome.
In future updates, I'll show you more examples of RSI Divergence testing results and how you can become a better RSI trader. Until then, be sure to look at my RSI divergence testing results on the daily chart of 27 currency pairs.
