RSI (Relative Strength Index) typically shows high values when the market is rising and low values when market is falling. However, while there are virtually no limits on where price can go (other than the price of zero), RSI value range is limited to 0 to 100. Furthermore, RSI measures the relative strength of up and down moves, but does not move perfectly in line with price.
Occasionally, price makes a new (higher) high and RSI fails to do so (the new high on RSI is lower than the previous high). Conversely, sometimes price makes new lower low, but RSI does not get below its previous low. These situations are called RSI divergences. There is a divergence, or mismatch, between the information we get from price (the market continues its trend and makes new extreme) and RSI (the market fails to break through the previous extreme and the trend may be reverting soon).
RSI Divergence as a Trading Signal
Some traders consider RSI divergence a powerful signal for trading against the trend – in other words, if you see a RSI divergence, there is high probability that the trend will reverse.
Bullish RSI Divergence
A Bullish RSI Divergence occurs when the price makes a new lower low, but the RSI doesn’t. This is considered a bullish (buy) signal.
Bearish RSI Divergence
A Bearish RSI Divergence occurs when the price makes a new higher high, but the RSI doesn’t. This is considered a bearish (sell) signal.
Nevertheless, no two RSI divergences are the same and as with any other technical analysis based strategy, it is the little details which decide whether a strategy will make of lose money in the end.
RSI Divergence Indicator
Some trading and charting software packages include various forms of RSI Divergence Indicator, which draws RSI divergences automatically into a chart and prints trading signals or alerts.
What Is a Divergence in General?
The word divergence is not used only in connection with RSI. In general, a divergence means that something behaves differently from something else. In economics or financial analysis, it means that two measures or statistics which normally tend to show similar developments are acting differently at a moment – for example, if US GDP is rising an EU GDP is falling, we can say that there is a divergence in US and EU GDP. In technical analysis, a divergence means that we are getting different signals or different information from two different indicators or (most often) different information from price and a technical indicator.