RSI is a widely used momentum indicator in the trading community, primarily for assessing a stock's strength and momentum. However, a lesser-known application is its ability to detect fading momentum, serving as a cautionary signal for potential reversals. In today’s newsletter, we will explore how to use RSI to spot weakening momentum.

RSI Divergence: What It Reveals About Momentum

RSI is primarily used as a momentum indicator. A rising RSI suggests increasing momentum, while a falling RSI indicates weakening momentum—its traditional application.

RSI divergence, however, offers a different perspective. RSI divergence occurs when the price and the RSI are not in sync. Let us understand two most common RSI divergences: Bullish Divergence and Bearish Divergence.

Bullish Divergence

In a Bullish divergence, the price makes a lower low, but RSI makes a higher low. This shows that the bearish momentum is slowly fading, and bullish momentum is increasing.

RSI’s calculation has a component of Average Gains divided by Average Losses over a specific number of candles. When Bullish RSI divergence forms, it shows that even though the price is forming a lower low, the Average gains are increasing, resulting in a divergence.

Bearish Divergence

Bearish RSI divergence is exactly opposite of bullish divergences. In bearish divergence, price forms a higher high, but the RSI forms a lower high.

Bearish divergence shows that although the price is making a higher high, the Average losses have been increasing in the past few candles, indicating that the bullish momentum is fading.

Examples

RSI divergence holds greater significance on higher timeframes like the Daily or Weekly chart. However, it can also be used on lower timeframes such as 15-minute or 5-minute charts for intraday analysis, however, these divergences will have a short validity and should be traded in the direction of higher timeframe.

A divergence does not always lead to a price reversal; at times, it may result in consolidation due to weakening momentum.

RSI divergence should not be traded in isolation; it needs context for effective use. Incorporating EMA channels helps provide this context, as the significance of divergence depends on where it appears on the chart.

Besides these, there are four more types of divergences. Identifying them in the right context and at key levels can provide a significant edge in trading. A few years ago, I created a video on RSI divergence, where I explained these concepts in detail. Take an hour this weekend to revisit and learn something new—watch the video and enhance your understanding.