RSI and Divergence Trading: Key Strategy to Anticipate Market Reversals

The Relative Strength Index (RSI) has established itself as one of the most reliable oscillators for detecting extreme conditions in price movements. However, its true predictive power lies in trading divergence, a signal capable of anticipating trend changes with significant probability. While RSI is not infallible, combining it with trend analysis makes it a decisive tool for disciplined traders.

Fundamental Understanding of RSI: Definition and Mechanics

The RSI, known as the Relative Strength Index, belongs to the family of momentum indicators or oscillators. Its main purpose is to quantify the magnitude of bullish versus bearish movements over a specified period, normalizing this ratio on a fixed scale between 0 and 100.

Two distinctive features of RSI:

(1) It smooths out extreme price fluctuations, eliminating noise that could distort analysis (2) It provides a constant oscillation band that allows positioning relative to the movement

Calculation Formula

For ‘n’ periods, the calculation is:

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

Where RSn represents relative strength:

RSn = Average of Bullish Closes / Average of Bearish Closes

The indicator compares the magnitude of upward versus downward movements, then normalizes this result within the 0-100 scale. It typically operates with a default of 14 periods, but it can be configured according to your trading strategy.

RSI Interpretation: Reading Extreme Signals

Overbought and Oversold Zones

Correct RSI reading requires attention to its critical zones:

When RSI ≥ 70 (Overbought): An asset is considered overbought, suggesting a probable future pullback. However, in strong uptrends, the price may sustain or even accelerate its rise if demand remains solid. Exiting this zone may indicate correction or consolidation, not necessarily reversal.

When RSI ≤ 30 (Oversold): The asset is considered oversold, anticipating a likely rebound. Nonetheless, with weak fundamentals, the price can remain depressed for extended periods. Exiting this zone may simply be a bullish correction within a dominant downtrend.

Critical Limitation: No oscillator replaces trend analysis. RSI indicates a necessary condition for trading, but confirmation on the chart through breaking key levels is the sufficient condition to execute positions.

Trading Divergence: The Most Powerful RSI Signal

Trading divergence occurs when inflection points in the price diverge from inflection points in the RSI indicator. This misalignment often signals an imminent reversal.

Bullish Divergence: Weakness at the Bottom

Occurs during downtrends when:

• Price forms lower lows
• Simultaneously, RSI forms higher lows
• The indicator is in the oversold zone

This decoupling indicates that selling pressure is weakening while demand is gaining ground, anticipating a subsequent upward move.

Practical example: In Broadcom (NASDAQ: AVGO), during a bearish phase, while prices fell to new lows, RSI remained at higher levels than previous lows, indicating residual demand. Subsequently, an uptrend developed that lasted two months.

Bearish Divergence: Exhaustion at the Top

Occurs during uptrends when:

• Price makes higher highs
• RSI simultaneously forms lower highs
• The indicator is in the overbought zone

This phenomenon reveals a loss of momentum despite new highs, warning of an imminent bearish reversal.

Example: Walt Disney (NYSE: DIS) showed this divergence when prices kept rising but RSI failed to reach new highs. The subsequent bearish reversal persisted for over a year afterward.

Practical Trading Signals with RSI

Buy Signal

Triggered when three sequential conditions are met:

1. RSI reaches oversold zone (below 30)
2. Then returns to the fluctuation band
3. Breaks the previous downtrend line

Illustration: Taiwan Semiconductor Manufacturing (NYSE: TSM) in September-October 2022 showed extended oversold conditions, followed by RSI recovery and subsequent break of its downtrend from January. This point validated a long entry.

Sell Signal

Established when:

1. RSI reaches overbought zone (above 70)
2. Then returns to the fluctuation band
3. Breaks the previous uptrend

Application case: Applied Materials Inc. (NASDAQ: AMAT) maintained RSI in overbought from November 2020 to April 2021, generating a strong uptrend. The subsequent return to the fluctuation band and trend break in January 2022 confirmed a short entry with sustained validity.

Operational Warning: RSI often makes multiple inflection points within extreme zones before returning to the band. Waiting for trend break confirmation prevents operational traps.

Trend Validation: The Middle Level as a Tool

The midpoint of RSI (level 50) divides the 0-70 bullish versus 30-70 bearish scale. This division is critical for validating continuation.

Validation Logic:

• When RSI oscillates between 50 and overbought (70), the price tends to rise steadily
• When RSI oscillates between 50 and oversold (30), the price tends to decline

In Meta Platforms (NASDAQ: META), after the oversold bottom in March 2020, while the indicator fluctuated between overbought and the mid-level, the uptrend was consolidated. Only when RSI crossed below the mid-level multiple times was the trend reversal to bearish confirmed in February 2022.

Implication: If the indicator does not cross the 50 level, we are dealing with corrections within the dominant trend, not fundamental trend reversals.

Operational Robustness: Combining RSI with MACD

RSI is susceptible to false signals, especially on shorter timeframes. Its combination with the MACD indicator significantly strengthens decision-making.

Integrated RSI-MACD System

Conditions for opening:

1. RSI reaches an extreme (overbought or oversold) - necessary condition
2. RSI returns to the fluctuation band
3. MACD performs a crossover over the histogram’s midline in the opposite direction - sufficient condition

Closing condition: MACD crosses its SIGNAL line in the opposite direction

Real application: Block Inc. (NYSE: SQ) showed initial overbought. After RSI returned and MACD performed a bearish crossover over the histogram, a short position was opened. The position was closed with MACD crossing over its SIGNAL line four months later in March 2022, although the downtrend continued afterward.

Summary: Practical Trading of Divergence

Combining divergence trading analysis with RSI transforms this oscillator into a first-order predictive instrument. Divergences capture misalignments between price and momentum that often precede decisive reversals.

For disciplined traders integrating RSI as part of a multidimensional analysis—validating with trend breakouts, combining with other oscillators, and respecting the necessary-sufficient hierarchy—this indicator significantly increases operational success probability in stock markets.