You will hear this word often when it comes to trading. So often that Trading the RSI with divergences may now be obsolete because every beginner is trading it, and big players of this market know it.
So, first advice before even teaching you to trade divergences, do not mind them if they are not confirmed yet and if you are watching a Low Timeframe (4Hours, 1Hours and below…)
Divergences can be spotted by comparing price movement and the RSI reaction.
Remember Higher Highs and Lower Lows? You should think that when the price is making Higher Highs, then the RSI should make Higher Highs too?
It happens that the RSI does not react in the same way than the price does. That is why we are calling it divergences!
Using divergence in trading can be useful to spot trend reversals or continuations.
Regular Bullish RSI Divergences
On this chart of BTC/USD, you can see here 2 beautiful Regular Divergences on the Daily Timeframe.
The price is making Lower Lows while RSI is making Higher Lows. This is a bullish setup, and the result of it was a short-term trend reversal.
This divergence occurs typically in a downtrend.
Regular Bearish RSI Divergences
On this chart of BTC/USD, you can see here a beautiful Regular Bearish Divergence on the Daily Timeframe.
The price is making Higher Highs while RSI is making Lower Highs This is a bearish setup, and the result of it was a trend reversal.
This divergence occurs typically in an uptrend.
Take your time to watch this chart more than 1 minute. This was the chart of Bitcoin when reaching $20,000. RSI Divergence was the one of the first indicator to announce the top of this asset.
While it might not be the most accurate indicator, it remains one of the most used to spot trend reversal.
Hidden Bullish RSI Divergences
On this chart of EOS/BTC, we can see the price doing Higher Lows, while the RSI is making a Lower Low. This Hidden Bullish Divergence usually occurs in an uptrend and confirms the continuation of the move up.
Hidden Bearish RSI Divergences
On this chart of ETH/USD, we can see the price making Lower Highs, while the RSI is printing Higher Highs. This Hidden Bearish Divergence occurs typically in a downtrend and will add confirmation of the continuation of the move down.
How to trade RSI with divergences?
Divergences may be easy to spot. They are more challenging to trade. From experience, it is often used by “whales” to trap people thinking an H4 Regular Bullish Divergence will instantly reverse the trend. Beginner traders also often forget to wait for confirmation.
The best confirmations to trade a Regular Bullish divergence are:
- Make sure the price does not continue to make Lower Lows after a few candles
- The RSI was below 30 – oversold conditions
- The RSI leaves the oversold area
Other confirmations exist, but they imply combining other indicators with the divergences, such as a good Support area.
When is a Divergence invalidated?
Again, this is a debate amongst many traders.
So far, there are 2 ways to invalidate Divergences, and many experienced traders use them.
The first one is to consider the period calculated by the RSI. By default, your RSI period will be set to 14. As explained in the previous lesson, it means the RSI is calculated with the 14 last candles.
If, after taking a position after confirming a Regular Bullish Divergence, the price does not make a new High after 14 candles, the trader will then re-evaluate his position.
The second option is to extend the line connecting the peaks on the RSI. This technique only works with Regular Divergences. If the RSI crosses this line, the Divergence is invalidated.
On this chart, you can easily notice the Regular Bearish Divergence. The price pulls back and we can extend the trendline on the RSI.
When the RSI crosses back the RSI trendline, the Divergence can be considered as invalidated, thus, the trader leaves the trade in profits.
This process is an easy way to lock the profits and avoid being in an uncomfortable position and never had taken any profits from the pullback.
Learn more by reading the 9 rules for Trading the RSI Divergences.