RSI and divergence trading: The technical compass you need to trade on the stock market

Have you ever seen how other traders seem to anticipate market turns? Much of that “sixth sense” comes from mastering tools like the RSI. This technical indicator is much more than numbers on a screen; it’s your radar for detecting inflection points in prices.

Why RSI Became the Favorite of Technical Traders

The Relative Strength Index (RSI by its initials) belongs to the oscillator family and measures one fundamental thing: the ratio between bullish and bearish closes over a given period. Its popularity is no coincidence. This indicator does two things very well: smooths out price noise and shows you the market’s relative position on a fixed scale from 0 to 100.

Imagine you’re on a roller coaster and want to know where you are in the ride. RSI is exactly that: it tells you if the price is at the peak (overbought), in the valley (oversold), or moving through the middle.

The Formula Behind RSI: Understanding Without Complication

You don’t need to be a mathematician to use RSI, but understanding its logic helps you trust the signals. The basic equation compares the strength of bullish movements against bearish ones:

The indicator takes the closing prices of upward and downward moves over 14 periods (this number can be adjusted according to your strategy), then normalizes everything on a 0-100 scale. The result is an oscillator that fluctuates within that constant range.

Interpreting RSI: The Three Zones That Matter

The Upper Critical Zone: Overbought (above 70)

When RSI crosses above 70, the market is in “overbought” territory. Now, this DOES NOT mean you should sell immediately. It means buyers have been in control and there’s a probability of a pullback. However, strong uptrends can remain overbought for extended periods as investors are willing to pay higher prices.

The Lower Critical Zone: Oversold (below 30)

When it drops below 30, we are in oversold territory. The market has been battered by sellers. Caution also applies here: although it may seem like a bargain, if the fundamentals of the asset are weak, it can keep falling. An oversold asset doesn’t necessarily bounce; it depends on the context.

The Middle Zone: Your Trend Compass (around 50)

This is the secret many traders ignore. If RSI oscillates between 50 and 70, the price tends to rise. If it oscillates between 50 and 30, the price tends to fall. When RSI crosses the 50 line downward, after being in positive territory, it’s a warning of a potential change in direction.

Practical Case: Tesla and Lessons from a Retracement

Let’s see how this worked in practice. In May 2019, Tesla (NASDAQ: TSLA) was in oversold territory according to RSI. The indicator then returned to its normal fluctuation band and the price started making higher lows, confirming an uptrend. During those periods, RSI reached overbought territory in February 2020, just as COVID impacted markets.

Was it the end? No. RSI retreated but didn’t cross the middle zone, suggesting a correction within the uptrend, not a change of direction. That’s how it was: the price kept rising.

This pattern repeated: every time RSI returned to overbought and retreated without crossing the middle level, it was a sign to buy more, not to sell. Finally, in October 2021, RSI hit overbought but something changed: it failed to reach that extreme on subsequent attempts. Simultaneously, the price began forming lower highs. In December, the uptrend broke and RSI fell into oversold territory. The change of direction was already a fact.

Meta Platforms: Validating Trends with the Middle Line

Another illustrative case involved Meta Platforms (NASDAQ: META). In March 2020, RSI hit oversold and bounced. From that point, as long as the indicator fluctuated between overbought and the 50 line, the price steadily rose. Each RSI retreat toward 50 was a buying correction, not a reversal.

The lesson: as long as RSI doesn’t fall below 50 after a correction, the uptrend remains intact. It was only when multiple overbought highs (June, July, August 2021) followed by retreats crossing the middle zone that the trend weakened. In February 2022, when the price finally broke the uptrend and RSI fell into oversold, the picture was complete.

Operational Signals That Work

Buy Signal: Three Conditions That Align

The classic buy signal occurs when:

1. RSI reaches oversold (less than 30)
2. The indicator moves back toward the normal fluctuation band
3. Price breaks a previous downtrend line

Let’s look at Taiwan Semiconductor Manufacturing (NYSE: TSM) between September and October 2022. RSI was depressed in oversold territory. Then it gradually recovered. When the price finally broke the downtrend line from January 2022, that was the long entry point. The indicator provided the early alert, but the trend break was the confirmation.

Sell Signal: The Opposite Triangle

Works the other way:

1. RSI hits overbought (greater than 70)
2. The indicator returns to normal band
3. Price breaks a previous uptrend line

Applied Materials (NASDAQ: AMAT) showed exactly this. Between November 2020 and April 2021, RSI remained in overbought while price continued upward. Then it retreated but without strong conviction. In January 2022, when the price finally broke the previous uptrend, it was time to go short. The downward move continued for months.

Divergence Trading: When Price and RSI Disagree

This is where things get interesting. When price and RSI move in different directions, we have divergence. These are the most powerful signals of potential change.

Bullish Divergence: Price Falls, RSI Rises

Happens when price hits lower lows within a downtrend, but RSI hits higher lows. This indicates sellers are losing conviction even as price continues to fall.

Broadcom (NASDAQ: AVGO) was an example. On the chart, descending lows in price were visible, but RSI was making higher lows. That meant demand was gaining ground. Indeed, the subsequent uptrend remained valid two months later.

Bearish Divergence: Price Rises, RSI Falls

The mirror: price hits higher highs but RSI hits lower highs. A sign of exhaustion on the buying side.

Walt Disney (NYSE: DIS) demonstrated this. Price kept making higher highs, suggesting the uptrend persisted. However, during the same period, RSI was creating lower highs. The oscillator was seeing a loss of strength that price had not yet reflected. The subsequent bearish reversal extended over a year.

Divergence trading is like seeing cracks in a building before it collapses. It’s anticipating, not reacting.

Combining RSI with MACD: When Two Indicators Are Better Than One

RSI has limitations. It can produce false signals, especially on short-term charts. Combining it with MACD (Moving Average Convergence Divergence) creates a more robust system.

The logic is simple:

1. RSI provides the necessary condition: reaches overbought or oversold
2. The indicator moves back to the normal band
3. MACD crosses the histogram’s midline in the opposite direction: this is the sufficient condition

Block Inc. (NYSE: SQ) was the example. In an overbought situation, the expectation was a bearish move. When RSI retreated, the confirmation came: MACD crossed downward through the midline. That authorized a short entry. Exit would occur when MACD crossed back above its signal line, which happened four months later.

This dual approach reduces false alarms and keeps you in valid trades longer.

Traps to Avoid

Trap 1: Acting on overbought/oversold without trend confirmation

RSI only indicates extremes, not necessarily a change. Always wait for a previous trend to break.

Trap 2: Ignoring the middle level in trends

If during an uptrend RSI retreats to 50 but doesn’t cross it, the trend is alive. Don’t confuse corrections with reversals.

Trap 3: Using only RSI on very short timeframes

On 5 or 15-minute charts, noise is amplified. Switch to at least 1-hour charts for greater reliability.

Trap 4: Forgetting fundamental context

An asset can be oversold because its fundamentals are weak, not because it’s a bargain. RSI is technical; fundamentals are the reality.

Conclusion: RSI as Part of Your Arsenal

RSI and its divergences are powerful tools, but they’re not magic. They work best as part of an integrated system that includes trend analysis, validation with other indicators, and disciplined risk management.

Technical indicator doesn’t replace chart analysis. It complements it. Seen this way, RSI becomes what it should be: a compass that guides you on where the market is and where it might go, always waiting for confirmation with real price movements.

Mastering RSI divergence, understanding its critical zones, and applying these signals systematically can make the difference between trading with an edge or against it. The market will remain volatile and unpredictable, but with these tools in your toolbox, at least you’ll know what to ask the charts.