Master RSI divergences and optimize your technical analysis strategy

What is the RSI indicator and why does it matter in trading?

The Relative Strength Index (RSI by its English abbreviation) belongs to the family of technical oscillators and has established itself as a fundamental tool for identifying extreme moments in price movement. Unlike other indicators, the RSI normalizes its readings on a fixed scale between 0 and 100, making it easier to interpret overbought and oversold conditions.

The calculation of RSI for ‘n’ periods follows this mathematical equation:

RSIn = 100 - [100 / (1 + RSn)]

Where RSn represents relative strength:

RSn = Average of Bullish Closes over n Periods / Average of Bearish Closes over n Periods

This indicator compares the magnitude of upward versus downward movements and normalizes the result on that 0-100 scale. It is generally set with 14 periods, although it can be adjusted according to your trading style.

Fundamental interpretation: RSI extreme zones

Overbought vs. Oversold: When do they act?

When RSI reaches values above 70, the asset is considered overbought. This condition suggests that buyers have excessively dominated the price and a bearish correction is likely to occur. However, it is crucial to understand that an asset can remain in overbought territory for extended periods if investors continue buying at higher prices. Exiting this extreme zone, the movement may be just a minor correction before resuming the previous uptrend.

Conversely, readings below 30 indicate oversold conditions. In these cases, the price has fallen excessively and is likely to bounce upward. However, persistence in this zone depends on the fundamentals of the asset: if they are weak, investors may be unwilling to pay higher prices, prolonging the decline.

The mid-level (50): The hidden compass

A frequently ignored aspect is the RSI mid-level at 50. This level acts as a trend validator:

• When RSI oscillates between 50 and 70, the price tends to rise
• When it fluctuates between 30 and 50, the price tends to decline

Let’s analyze the case of Meta Platforms (NASDAQ: META). In March 2020, the indicator reached oversold levels. When it exited that zone, the RSI remained fluctuating between 50 and the overbought zone, confirming a bullish consolidation of the price. As long as the indicator did not fall below the mid-level, any retracement was just a correction within the current trend. This dynamic lasted for months, allowing traders to maintain long positions with confidence. The decisive break came in February 2022 when RSI finally crossed below 50 into the oversold zone, signaling a change in direction.

Trading signals: From theory to practice

Structured buy signal

A valid long entry requires the fulfillment of three simultaneous conditions:

1. RSI reaches oversold zone (below 30)
2. The indicator returns to the normal fluctuation band
3. The price breaks a previous downtrend line

Consider Taiwan Semiconductor Manufacturing (NYSE: TSM) between September and October 2022. RSI entered oversold and remained there for weeks. Subsequently, it began to recover within the fluctuation band. Confirmation came when the price effectively broke the downtrend line that had been developing since January. This breakout was the ideal moment to open long positions.

Sell signal structured

Similarly, for short operations, three conditions are needed:

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

In the case of Applied Materials Inc. (NASDAQ: AMAT), between November 2020 and April 2021, the indicator remained overbought while a strong uptrend was developing. From there, it retreated to the normal band and the price formed a lateral range. The definitive break of the uptrend occurred in January 2022, when a short position could have been opened with favorable odds.

RSI divergences: The silent weapon of technical analysis

Bullish divergence: Anticipating reversals upward

RSI divergences represent moments when the indicator’s behavior decouples from the price movement. A bullish divergence occurs during a downtrend when RSI forms higher lows while the price forms lower lows. This disconnect suggests that selling pressure is waning and that a reversal is imminent.

Practical example with Broadcom (NASDAQ: AVGO): In a clear downtrend, the price continued forming progressively lower lows. However, RSI started to mark higher lows, indicating that demand was gaining internal strength. This bullish RSI divergence materialized in a significant reversal that generated an ongoing uptrend for months.

Bearish divergence: Warning of loss of momentum

A bearish divergence arises during uptrends when RSI forms lower highs while the price forms higher highs. The indicator captures the loss of market strength even when prices superficially continue rising.

The case of Walt Disney (NYSE: DIS) perfectly illustrates this. The price was making higher highs suggesting bullish continuation. However, RSI was marking progressively lower highs, revealing that buying momentum was weakening. This bearish RSI divergence preceded a reversal that remained in effect for over a year.

Reinforcing decisions: RSI-MACD combination

RSI has limitations, especially on very short timeframes where it frequently generates false signals. An effective solution is to combine it with MACD (Moving Average Convergence-Divergence), another momentum oscillator.

The combined system works as follows:

1. RSI reaches extreme zones (overbought or oversold) — necessary condition
2. RSI returns to the fluctuation band
3. MACD line crosses the histogram’s midline in the opposite direction of the trend — sufficient condition for entry
4. MACD line crosses the SIGNAL line in the opposite direction — exit signal

In the case of Block Inc. (NYSE: SQ), RSI indicated overbought. Then it retreated while MACD line crossed below the histogram’s midline, confirming a potential downtrend. This confluence of signals allowed opening a short position. The exit was executed four months later when MACD crossed above the SIGNAL line. This combined system significantly reduces false signals.

Historical cases: Tesla and Meta under the RSI lens

Tesla (NASDAQ: TSLA) 2019-2022

Between May and August 2019, Tesla was in oversold territory according to RSI. The indicator’s recovery coincided with the break of a downtrend line, signaling a long entry. Later, in February 2020 during the COVID-19 crisis, RSI reached overbought. However, it did not collapse fully into the mid-zone, indicating it was a correction within the current trend. The uptrend continued.

Between June and December 2020, RSI made multiple highs in overbought territory without significantly descending. This confirmed minor corrections, not trend reversals. It was the perfect opportunity to increase long positions.

The definitive break came in October 2021 when RSI failed to reach the overbought extremes again. Simultaneously, the price started forming lower highs, creating a new downtrend line. In December, the previous uptrend was broken, marking the start of the corrective phase that persists.

Technical analysis beyond RSI

It is essential to remember that no technical indicator, not even RSI or its divergences, replaces trend analysis on charts. Oscillators should be considered necessary but not sufficient conditions. Validation through chart patterns, trend lines, and resistances is the sufficient condition to execute trades with confidence.

RSI divergences are powerful tools when used correctly, but always in conjunction with other analysis techniques.