RSI divergences: What they are and how they work

RSI divergences occur when the price of an asset moves in one direction while the Relative Strength Index (RSI) moves in the opposite direction. This indicates a mismatch between price action and momentum, often hinting at a trend reversal or pause. 

Traders use RSI divergences as a potential early sign that a trend is running out of steam, helping to identify tops and bottoms. 

Applied on both lower and higher time frames, traders can use divergences to either open or close positions. 

The Relative Strength Index (RSI) is a momentum oscillator that measures how fast and how much the price of an asset has changed over a certain number of periods, usually 14. It gives a value between 0 and 100.

Instead of diving into the full math, here's a simple way to think about it:

• RSI compares recent gains and losses.
• If the asset has had more and bigger gains than losses over the past 14 periods, RSI will be higher (closer to 100).
• If losses outweigh gains, RSI will be lower (closer to 0).

Traders use the RSI to spot when an asset might be overbought (typically above 70) or oversold (below 30), which can signal a possible price reversal. Most charting tools calculate RSI automatically, so you don’t need to do the math manually. The focus should be on interpreting what the number means.

RSI is widely used across markets including stocks, forex and crypto due to its versatility and visual clarity in indicating momentum shifts.

Divergence arises when price makes a new high or low, but RSI fails to do the same:

• Bullish divergence: Price makes a lower low; RSI makes a higher low.
• Bearish divergence: Price makes a higher high; RSI makes a lower high.

Simply put, divergences suggest the trend may be weakening, signaling that the momentum behind a move is not as strong as it appears. Oftentimes, price action can look at its most bullish just before it’s about to have a violent reversal. In these instances, divergences help traders identify when such reversals are more likely. 

Working with probabilities over certainties is important in trading—it is never 100% certain that a market will reverse, but there are signals that suggest a reversal is more likely. 

Divergences are one such signal, and by backtesting how and when such divergences convert into reversals can help improve overall strike rate. 

Occurs in a downtrend. Price makes lower lows, but RSI makes higher lows. Indicates weakening bearish momentum. It suggests that even though prices are dropping, the intensity of selling is decreasing. This could precede a price bounce or a trend reversal to the upside.

Occurs in an uptrend. Price makes higher highs, but RSI makes lower highs. Suggests bullish momentum is fading. Traders often use this signal to prepare for potential short positions or to exit long positions at a profit.

Seen in uptrends. Price makes a higher low, but RSI makes a lower low. Signals trend continuation. It’s a subtle cue that the prevailing trend still has strength and that a temporary pullback may be ending.

Seen in downtrends. Price makes a lower high, but RSI makes a higher high. Indicates downtrend continuation. This is often used to reinforce short entries during minor rallies in a broader downtrend.

Understanding these variations helps you align your trading decisions with the current market structure.

1. Add RSI to your chart (typically 14-period).
2. Mark key highs/lows in both price and RSI. Some charting platforms allow you to set alerts based on RSI values or levels. 
3. Identify when a divergence is in play, then determine whether any action is necessary. 
4. Use breaks in market structure (a break of key support/resistance levels) as additional confirmation that a reversal is playing out. 

To help you identify a divergence, you can draw a line connecting the two peaks or troughs in both the price and RSI windows. If the lines slope in opposite directions, then a divergence is present. 

RSI divergence tends to be more reliable on higher timeframes (daily candles and above) and after a prolonged trend. It’s less effective during extremely strong parabolic trends where taking a position in line with the divergence would amount to fading the higher time frame trend. During such moves, momentum and price can remain disconnected for longer periods.

Context matters. It’s important to combine RSI signals with other information that acts as confluence for your overall trade idea. For example, a bearish divergence in isolation may not offer much signal. But a bearish divergence at a major higher timeframe resistance level, coinciding with a bearish candlestick pattern and a large spike in volume is more convincing. 

1. A divergence does not mean a reversal or continuation will definitely occur. In very strong trends, markets can simply pause for a while, consolidating before the next move. A divergence just means that a pause or reversal is more likely, nothing more.
2. Divergences can be invalidated. What may appear to be a divergence forming on the RSI can just be one leg of a very strong trend. It’s possible for a higher high to form on the RSI in the extreme zone (above 70, making a divergence more likely) only for another higher high to take place. This would invalidate any previous indication of a bearish divergence. 
3. The lower the time frame, the lower the significance. A divergence on the one minute chart indicates a higher probability of a reversal solely on that time frame. While in theory a major higher time frame reversal could begin with a lower time frame divergence, we cannot assume this to be the case. If the higher timeframe trend is intact, we can only deduce that a lower time frame divergence indicates a temporary pull back. 

• There are a range of other tools and technical indicators that you can use to help build your case that a reversal is probable. Find those that you like and that appeal to you and incorporate them into your analysis alongside the RSI. 
• Analyze multiple timeframes to get a greater sense of the overall likelihood of a reversal. Price action often offers clues across several different time frames which can offer greater confidence that a reversal is about to take place. For example, you may see a confluence of bearish candle patterns across multiple time frames after identifying a bearish divergence.
• Use price levels above and below your entry for invalidation if the market in question does not trade as you expect it to. Placing a stop loss order can be helpful to cap your risk in case you are wrong. Crypto markets are extremely volatile and fading parabolic trends can be costly without a stop in place. 
• Think in probabilities, not certainties. No trade, however strong it may appear to be, is certain to succeed and the market can change its mind in a heartbeat, owing to a range of factors. As Mark Douglas once wrote of markets, “anything can happen.” 
• You don’t have to dive into a trade the moment a divergence is present. Fading strong trends is dangerous so you must be confident that a reversal is more likely than not before entering the trade. You can wait for a confluence of signals rather than relying solely on RSI—some traders use a checklist before entering a trade, for example. 
• If you are trading altcoins, track how Bitcoin (BTC) and other financial markets (such as SPY and NASDAQ) are behaving. These markets account for a significant percentage of the variance in price action in altcoins. For example, if Bitcoin is in a strong uptrend, and you are trying to short an altcoin, Bitcoin’s relative strength may impact on the likelihood of success of your short position. If you see the same divergence on BTC and other related assets, this may increase strike rate. 
• Use the candle closes when determining an RSI divergence, not the wicks. This will help you better identify when a divergence is present. 

• Entry: After confirmation (e.g., RSI crosses key level or price breaks trendline).
• Stop-loss: Just beyond the recent high/low.
• Take profit: Near previous support/resistance.

Consider adopting this strategy when market sentiment is shifting and is paired with trendline breaks or support/resistance reversals.

• Entry: On trend pullback showing hidden divergence.
• Confirmation: RSI crosses back over 50 or price resumes trend.

This strategy has a higher probability of success in healthy trends. Hidden divergences are best used by trend followers seeking re-entry points.

Back in November of 2022, Bitcoin (BTC) and the wider crypto market formed a bottom. After several months of panic and fear driven price action, the downtrend eventually came to end. 

If you look at the weekly Bitcoin chart, in combination with the RSI and volume indicators, you can see that (in hindsight) there were a couple of clues that the bottom was forming:

1. There was a clear weekly bullish divergence between price and the RSI. Price made a lower low (the precise bottom was ~$15,500) but the RSI formed a higher low. You can easily draw a downward trendline between the highs on the Bitcoin chart and an upward trendline on the RSI. 
2. Volume climaxed with a big spike at the precise low of the move. This is common at the bottom of major down trends, as the last of the sellers capitulate before the market reverses.

RSI divergence is a powerful tool for spotting potential reversals and continuations. Regular divergence indicates a possible trend change, while hidden divergence supports staying with the trend. 

By training your eye to recognize these patterns and using them within a broader strategy, you can enhance your timing and trade with greater confidence. Remember, RSI divergence doesn’t guarantee anything, but when combined with good risk management and technical confluence, it offers signals that can be traded effectively. 

Now that you understand the power of RSI divergences, it’s time to turn insights into opportunity. Start trading hundreds of cryptocurrencies and tokenized equities on Kraken today, and apply your edge in real markets!