RSI and Divergence Phenomenon in Trading: Master This Powerful Signal for Probabilistic Trading Success

In stock and digital asset trading, the Relative Strength Index (RSI) is a powerful tool for identifying extreme market conditions. But even more impressive is that RSI divergences often serve as early warnings of price reversals. However, note that RSI is not万能—it is just one weapon in your toolbox and must be combined with other analysis methods to maximize its effectiveness.

The Essence of RSI: Seeing Through Market Extremes

What is RSI? This technical indicator belongs to the family of momentum oscillators, officially called the Relative Strength Index. Its core function is to compare the strength of upward closing prices and downward closing prices over a period, presenting the result on a 0-100 scale.

RSI is useful for two main reasons: first, it smooths out extreme price fluctuations, reducing noise interference; second, its fixed 0-100 range allows you to quickly see the relative position of the price.

How to calculate RSI? The standard formula is: RSI = 100 - [100 / (1 + RS)], where RS equals the average of upward closes over n periods divided by the average of downward closes over the same period. Most traders use 14 periods as a parameter, but you can adjust based on your trading style.

Understanding the Two Extremes of RSI: When to Be Alert

RSI is particularly meaningful in two critical zones:

When RSI ≥ 70, the asset enters overbought territory. This usually indicates a price correction, but don’t rush to short. In strong bullish trends, the asset can stay in this zone for a long time. Even if the indicator eventually drops, it may just be a correction within the trend, and prices can continue higher afterward.

When RSI ≤ 30, the asset enters oversold territory. Theoretically, prices should rebound, but if the fundamentals are poor, investors may not want to buy, and prices can stay depressed for a long time. Similarly, falling out of this zone might just be a phase rebound, and the main downtrend could still be ongoing.

The key point is, relying solely on RSI signals is not enough. You must combine it with trend lines for validation. RSI is a leading indicator, providing necessary conditions; only confirmed trend breakouts are sufficient conditions, which increase the probability of successful entries.

Case Study: Understanding RSI Through Tesla’s Price Movements

From 2019 to 2022, Tesla (NASDAQ: TSLA)’s weekly chart clearly demonstrates how RSI can warn of trend reversals:

In May 2019, Tesla’s RSI dipped into oversold territory but then rebounded and broke through the previous downtrend line. This was a buy signal. In the following months, the price indeed entered an upward trend, with RSI rising accordingly.

In early 2020, during the pandemic shock, RSI briefly surged into overbought territory, but the price did not break the upward trend line, and RSI quickly returned near the midpoint (50). This indicated a correction, not a reversal. Long traders should have added to their positions.

Throughout mid to late 2020, RSI repeatedly hit highs in overbought zones but never fell below the midpoint, and prices remained stable in an uptrend. The logic is clear: as long as RSI oscillates above 50, the uptrend remains alive.

The turning point came in October 2021. Although RSI was still in overbought territory, the recent high was lower than the previous one. Meanwhile, the price formed lower highs. This divergence—RSI and price moving in opposite directions—is a divergence signal. Two months later, Tesla broke below the uptrend line, RSI dipped into oversold, and a bear market began.

Using the RSI Midpoint (50) to Judge if the Trend Is Still Alive

This is a small but often overlooked tip. On Meta Platforms (NASDAQ: META)’s weekly chart, you can see:

In March 2020, META’s RSI bottomed out in oversold territory and then rebounded, oscillating between overbought and 50, with the price steadily rising. The pattern is: as long as RSI stays above 50, the uptrend is still alive; if RSI falls below 50, the downtrend dominates.

Repeated peaks in overbought zones may seem strong, but if one high is lower than the previous, be cautious. Combining this with whether the price’s highs are also lower can help judge if a trend reversal is imminent.

In early 2022, META indeed reversed—price broke below the uptrend line, RSI fell into oversold. In the following months, RSI oscillated between oversold and 50, with prices continuing downward. This is the “sequel” of a downtrend.

RSI Trading Signals: Patterns for Buying and Selling

( Buy Signal: Three Conditions

To go long with RSI, all three must be met:

1. RSI enters oversold (< 30)
2. RSI rebounds back into normal fluctuation zone
3. Price breaks through the previous downtrend line

Take Taiwan Semiconductor (NYSE: TSM) as an example. From September to October 2022, RSI remained in oversold territory and then rebounded. Once the price broke through the previous downtrend line, the buy signal was confirmed.

Remember, RSI is a leading indicator; wait for the price to confirm the trend breakout before acting.

) Sell Signal: Three Conditions

The logic for shorting is symmetrical:

1. RSI enters overbought (> 70)
2. RSI falls back into normal zone
3. Price breaks below the previous uptrend line

Applied to Applied Materials (NASDAQ: AMAT), which was in prolonged overbought from November 2020 to April 2021, the subsequent months saw oscillations downward. In January 2022, the price finally broke the uptrend line, signaling a short entry. This bearish move lasted several months.

Divergence Trading: When Does RSI Signal Reversals?

Bullish Divergence: The Strongest Reversal Signal

Imagine this scenario: the price makes a new low, but RSI’s low is higher than before. This is called bullish divergence and is a strong reversal indicator.

Semiconductor company Broadcom (NASDAQ: AVGO) is a textbook example. During its decline, the price made lower lows, but RSI’s lows were rising. This indicates weakening selling pressure and accumulating buying interest. Two months later, the trend reversed upward and continued.

Bearish Divergence: The Strongest Downtrend Signal

Conversely: the price makes new highs, but RSI’s highs are lower than before. This is bearish divergence, signaling selling pressure is about to dominate.

Disney (NYSE: DIS) experienced this. The price kept rising, but RSI’s peaks were declining. The market sentiment felt strong, but the technicals were signaling trouble. Eventually, the stock reversed and the downtrend persisted for over a year.

Divergence is one of the most reliable reversal signals in technical analysis. Serious traders should incorporate it into their decision-making framework.

Amplifying RSI’s Power with MACD

RSI can sometimes mislead, especially on short-term charts with lots of noise. Combining it with MACD, a momentum indicator, yields more robust signals.

MACD has three lines: the main line, signal line, and histogram. Key rules are:

• RSI entering extreme zones (overbought or oversold) is necessary
• RSI returning to the middle zone
• MACD histogram crossing zero, with direction opposite to the trend—this is a sufficient entry signal
• MACD main line crossing the signal line in the opposite direction—this signals exit

Looking at payment company Block Inc. (NYSE: SQ), RSI showed overbought and then declined, but the critical confirmation was MACD histogram crossing zero from positive to negative, confirming the start of a decline. Based on this system, traders should open short positions, holding until MACD’s main line crosses above the signal line—this signal appeared four months later.

Although the stock continued to fall afterward, without a clear exit system, greed might cause you to give back all profits.

Final Words

RSI and divergence phenomena are powerful tools for entering and exiting stock or crypto markets. When combined with other indicators for validation, the success rate can be significantly improved. Remember: indicators are tools for probability games; mindset and risk management are the true secrets of success.