How to Determine Divergence by Relative Strength Index (RSI)

Summary: Relative Strength Index (RSI) is widely used as an effective technical indicator. It detects market overbought or oversold situation. If you always buy oversold and sell overbought, you are going to be a winner in the stock market or ETF trading. RSI can be used to detect bullish or bearish divergence by comparing the RSI level and price movement. Divergence is a compelling tool that can discover looming market reversals by comparing RSI value and the price movements of shares. 

One popular use of the RSI is to determine divergence. Divergence is a compelling tool that can discover looming market reversals by comparing RSI value and the price movements of shares. 

When you trade ETF, if the trending momentum (which is justified by RSI) does not bolster the price, an implied reversal might be in sight.  Basically, divergence can be divided into two types: one is bullish divergence, the other is bearish divergence.

          Bullish divergence takes place when a share’s price reaches a new low, but the RSI does not follow the footsteps.          

The ETF SSO (ProShares Ultra S&P 500), pursues daily investment results that resemble two times the daily performance of the S&P 500 index. It reached the low of that cycle at 37.56 on 8/10/2011.  On 10/3/2011, it touched another cycle low at 35.82, which was lower low, but the RSI (5) was 29, holding above a prior low of 23 on 8/10/2011. The bullish divergence formed between August and October 2011, and SSO went up steadily from the bottom on 10/3/2011. The breakout in November endorsed this reversal momentum.

When a bullish divergence is detected, even if the underlying security is in a declining mode, the sell-off is in check. Bearish momentum is controlled. Thus, the market condition does not deteriorate further, and the fear does not spread to a greater extent. It would be a good time to accumulate shares and wait to grow your profit.

          On the other hand, negative divergence occurs when a share’s price records higher highs, but the RSI does not reach higher high accordingly. 

For example, if an ETF is making a new high, while the RSI is not, this is an indication that the uptrend may be ending soon (bearish divergence). The signal usually comes when the RSI line drops below its most recent trench.

QLD (ProShares Ultra QQQ) tallies to two times the daily performance of the NASDAQ-100 index. On 7/19/2007, QLD closed at 49.76 on 7/19/2007, the highest price of that cycle. The RSI (5) reading was 88.  On 10/31/2007, QLD reached a multiple years’ high at 57.79. However, the RSI (5) was 78, which did not close at a higher high.  The negative divergence was formed. The QLD had a sharp dive since then until March 2009.     

Another usage of the RSI is to trade securities after confirming the extreme market condition (top or bottom). You might lose the best trading opportunity, but it is safer for you to make bets. 

Divergence often signals that the market could turn around, and it works especially well in a range-bound market.