What Is RSI Divergence?

With RSI divergence, the relative strength index of a specific stock shows lower highs when the price uptrend hits higher highs. Conversely, when the price is trending downward, it will hit lower lows with divergence while the RSI hits higher lows. While both indicators are either traveling upward or downward simultaneously, the RSI is beginning to diverge from the stock price.

Divergence indicates that the current price trend is flagging, which provides insight into whether it’s time to make a move to buy or sell that particular stock. When an indicator disagrees with the price, this lack of synchronicity indicates a likely change with the chart.

A hidden bullish divergence indicates the continuation of an upswing. You’ll notice on the trend lines that the RSI indicator makes a lower low than the price, which hits a higher low. Conversely, a hidden bearish divergence happens when a stock is trending downward. This trend will likely continue when you notice that the RSI hits a higher high than the lower high of the price. Either of these provides the information you need to make a smart stock move.

The Role of Relative Strength Index

To truly understand RSI divergence, we must first define RSI. This acronym, which stands for relative strength index, helps measure the direction and momentum of a specific stock. Generally, RSI looks at gains and losses over a 14-day period, although some traders rely on shorter and longer time intervals in various circumstances. An RSI indicator increases when a stock increases in value and decreases when the opposite is true. RSI is measured on a scale of 0 to 100. When it drops below 30, the stock is oversold and has likely been trending downward for some time. Conversely, RSI of 70 or above indicates a stock on an uptrend that is now overbought.

To calculate RSI, divide the average gain in the stock’s up periods by the average loss in the stock’s down periods. Add one, then divide the result into 100. Subtract the resulting number from 100 to find your RSI. For example, if the average gain over 14 days is 50 and the average loss is 20, your equation would look like this:

100-100/(1+50/20) = 100 – 100/1 + 2.5 = 100 – 28.57 = RSI of 71.43.

Traditionally, proponents of this indicator advocate selling stock when RSI exceeds 70 and buying when RSI drops below 30. However, these numbers are just guidelines and should not be used when you plan to go short or long with a stock. Instead, use RSI as a secondary indicator to support a separate primary buy or sell indicator.

Drawing a Trend Line for RSI Divergence

RSI trend lines are slightly different than traditional trend lines. When looking for divergence, draw a line from the highest high or lowest low to the previous highest high or lowest low. Ignore smaller dips and changes that take place between those peaks and valleys. Compare these lines with the price action trend lines for that stock. Make sure you are comparing highs to highs and lows to lows, not highs to lows or vice versa. If the slope of the indicator line is different from the slope of the price line, you’ve found a divergence!

Using RSI Price Divergence

RSI divergence is primarily used to determine when it’s time to sell because prices are likely to drop or when a general trend reversal is in the cards. As a leading indicator of a trend reversal, divergence should be combined with other technical analysis methods when making the decision to act on a specific investment. For best results, rely on RSI when you are dealing in a market that is choppy or range-bound. In this case, divergence can help you locate the top and bottom of the market. As with other types of indicators, you can adjust RSI divergence based on your trading preferences and strategies.

Keep in mind that while divergence typically represents a shift in price action, it does not necessarily mean a strong reversal will follow. Often, this type of asynchronicity simply indicates a momentum loss. Try filtering by location so you are looking at potential divergence and trend changes only once the price moves into a designated resistance or support zone.

Understanding Stock Momentum

You already know that RSI is a key indicator of an investment’s momentum. But how does momentum affect your trading action? Short-term price swings, which are easily detected by looking for RSI divergence, show up on your chart as steep slopes with a long price swing when momentum is strong and a short price swing and shallow slope when momentum of a particular stock is weak. As an upswing grows longer, momentum grows stronger. When price is choppy on a specific chart, use RSI divergence to smooth the trend line and obtain a clear picture of swings in price. Momentum is calculated with the formula M = CP – CPx, where CP is the current closing price and CPx is the closing price from the beginning of the period you are analyzing.

Pairing Divergence With Other Signals

RSI divergence works well with a host of other technical analysis strategies. Try some of these ideas to integrate this powerful indicator within your existing trading routine:

• The Bollinger band strategy will give you information about prices above and below market value when used along with RSI divergence analysis. Bollinger bands are one of the most widely used stock tools and provide data that lets you know when to buy, sell, or trade a stock. With this tool, locate a moving average line and place bands on either side determined by the amount of standard deviation. This allows you to gauge stock volatility and plan your next steps.
• RSI in combination with a candlestick strategy can provide insight about resistance and support zones as well as price structure. Primarily used in day trading, candlestick charts indicate whether a specific stock is bearish or bullish over your designated time frame. With this strategy, traders can plan exact entry and exit from the market to optimize profit.
• Try a moving average cross strategy, which provides crossover, support, and resistance signals, along with RSI divergence to confirm trends. With this strategy, a change in trend is indicated when the trend line for the moving average crosses over a designated point.
• Moving average convergence/divergence(MACD) can optimize profits when paired with RSI to look for histogram crossovers and daily support and resistance levels. Like RSI, this strategy also looks at trends and momentum in an attempt to predict the next movement of a stock.

Remember that if you find a divergence and the price has already reversed, you’re too late to act on this particular intelligence. The longer your time frame, the more accurate your signals and the less likely you will be to lose out by acting on a false signal. For RSI, the ideal chart time is one hour, though some seasoned traders even use 15-minute charts to take advantage of this strategy.

Experts recommend looking for a profit of 15 to 20% when swing trading. With the signals of a trend reversal, you can time your buy and sell action with greater accuracy, significantly improving your bottom line thanks to the info you gather from divergence.

What are Bollinger Bands and how can you use them? If you want to start trading stocks, there’s a lot to learn. One key tool when you start trading stocks is technical analysis.

Technical analysis uses chart patterns to signal when to buy, sell, or to short a stock. There are a lot of different indicators available, but one of the most widely-used tools is Bollinger Bands.

It’s simple to use, and nearly all charting software offer this indicator. Let’s look at how to use Bollinger Bands to signal when to buy, sell or short a stock.

Bollinger Bands: How to Start Trading Stocks Using Technical Analysis

The Origin of Bollinger Bands

Bollinger Bands are actually a technical analysis tool that was invented by John Bollinger, after whom it is named, in 1983.

Bollinger Bands, at the very basic, help detect spikes in price movements over the short term. The tool is invaluable to traders it helps to determine the volatility of stock and price dynamics.

What Are Bollinger Bands?

Bollinger bands take the form of an envelope or of “bands” that are placed both on the upper and the lower sides of a moving average line. Volatility is directly linked to the standard deviation which statistically measures the variation around an average value. The shape of Bollinger Bands is a function of the volatility, which means that as volatility rises, the bands take a wider form and when they decrease, the bands contract in size.

Actually, Bollinger Bands consist of three bands. The middle band is the moving average, and the upper and lower band are deviations from the moving average. The upper band is set by a certain number of standard deviations of the price., and the same goes for the lower band. Therefore, this indicator takes into account volatility.

The whole idea behind the indicator is that if a stock’s price is above the upper or lower band, it indicates the stock price might “too high” or “too low” and provide indicators to alert a trader whether it is time to buy, sell, or short a trade.

How to use Bollinger Bands to Gauge Volatility Trends

It is no hidden fact that volatility keeps changing. In general, the market shifts from high volatility periods to low volatility periods and the reverse trend is also possible. However, new traders can find it extremely difficult to gauge volatility trends in the market.

This is when Bollinger Bands come to your rescue because he width of the bands could be used as an indicator of volatility. We just discussed how the bands vary with volatility which means this could be used for an analysis of the volatility metric. If the bands are narrow, it indicates there’s less volatility. On the other hand, when the bands are wide, it means the stock experiences higher volatility.

Configuring Bollinger Bands

Generally, traders like to use the 20-period moving average for the middle band. Thereafter, they may set the standard deviations to 2. Thus, the upper band would be 2 standard deviations above the 20-period moving average. Additionally, the lower band would be 2 standard deviations below the moving average.

Now, let’s look at some trading strategies depending on Bollinger Bands following which we shall see some examples to give you a better idea of how to start trading stocks using technical analysis.

Using Bollinger Bands For Developing Trading Strategies

Bollinger Bands can serve as indicators of trends which can help you decide how to trade stocks at a particular point in time.

You will see the volatility grows as an indicator of strong trends. The bands will move away to start with.

Using Squeezes

There’s an interesting term called “squeeze” which is used to refer to the condition of low volatility. It is marked by narrow bands – in fact, you can quickly identify a squeeze by examining Bollinger Bands for the 6 month period. The area where the bands “squeeze” to the narrowest is where the squeeze is located.

Interpreting Bollinger Bands Correctly

Stocks are considered to be pricier when the price is close to the upper band. Conversely, when the price is closer to the lower Bollinger Band, stocks are cheaper. That said, this does not imply you can straightaway start trading at these points.

You see, it is also important to interpret Bollinger Bands in the right way. For instance, beginners often commit the blunder of buying when the stock price meets the lower band. Similar is the case when they decide to sell on seeing the price hit the upper band.

However, experts warn against making buying or selling decisions merely on the sign of the price hitting the lower or upper bands, and this is definitely not the best strategy for you to use.

The Double Bottom Strategy

An interesting pattern to look out for is the first time in the observation period when the price hits the lower band. At this stage, you should wait and watch where it is that the next price dip occurs in relation to the Bollinger Band.

The double bottom strategy suggests that traders can be very successful in their endeavors if they buy at the time of the second price low.

Consider when the first price low either hits the lower band or is outside it and the price then increases up to nearly the middle band, reacting, following which the second price low appears within the lower band confines. This is suggested as a great time to buy as it could strongly indicate an upcoming price rise.

You should also consider going through our resource on Bollinger Bands which presents the best practices you should keep in mind when using this tool in your trading.

Bollinger Bands Examples

Check out the daily chart on Michael Kors Holdings Ltd. (KORS).

Now, we set the Bollinger Bands to 20 and 2. That means we used a 20-day simple moving average (SMA) and 2 standard deviations.

If you look at the chart above, you’ll see some horizontal lines. These could be used in conjunction with Bollinger Bands. Notice how KORS formed a top around $70, and the first time it broke above the upper band, it reversed the next day and found support around $67. After it broke the lower band, the stock rallied and approached resistance again and was above the upper band.

This would be a short signal. You could have shorted the stock around $69 and placed a stop above $70, which was the previous high. This pattern is known as a double top and is considered a bearish pattern. If you shorted the stock at those levels, you could have had some nice gains. Moreover, you could have covered your shares once the stock’s price broke below the lower band.

When a stock’s price breaks above the upper band, it signals a reversal is in the cards and the stock could fall. Conversely, if the price breaks below the lower band, it signals the stock could reverse and run higher.

Here’s a look at KORS again, but this time we’ll focus on looking at when to buy the stock.

You could also use bands to signal when to buy a stock. If you look at the chart above, you’ll notice KORS had some support just below $57. You could have used that level as a stop. Notice the encircled area.

KORS broke below the lower band and you could have bought shares around $57.10 and stopped out if it broke below $56.50. The stock reversed after breaking the lower Bollinger Band and hit a $69 a few days after.

When you’re using Bollinger Bands, you should consider combining the tool with other indicators. For example, you might look at earnings, short interest, momentum and chart patterns.

Final Words

You could start trading stocks using technical analysis once you have got a good grasp of some indicators and Bollinger Bands could be a powerful tool in this regard.

However, you should use this indicator with other tools, such as support and resistance, trend lines or other technical patterns. Moreover, you might want to use technical analysis with catalyst events, which should increase the probability of success.

Keep in mind that technical analysis is an art, and the stock could still continue higher or lower, even if it breaks above or below the upper or lower band, respectively.

Ultimately, it’s all about developing a deeper understanding of how the market works and honing your skills with these tools to use them the right way. We highly recommend checking out this amazing resource on Bollinger Bands which has excellent tips and guidance from Raging Bull’s traders. You’ll find that it packs in time-tested strategies for you to benefit from when trading in the markets.