Let’s move beyond the basics and introduce a more advanced concept: RSI Divergence.

Divergence occurs when the price of a Forex currency pair makes a new high or low, but the RSI indicator does not confirm this movement. This can be a powerful signal that the current trend is losing momentum and a reversal may be imminent.

What is RSI Divergence?

RSI Divergence is a critical concept for traders, as it indicates a potential reversal or weakening of the current trend. Divergence happens when the price of a currency pair and the RSI are not aligned:

• Bullish Divergence: This occurs when the price moves to a new low, but the RSI forms a higher low. This suggests that despite the lower price, the momentum is starting to shift upwards, signalling a potential buying opportunity.
• Bearish Divergence: This occurs when the price reaches a new high, but the RSI fails to make a new high, instead forming a lower high. This suggests that the momentum of the uptrend is weakening, signalling a potential selling opportunity.

How to Spot RSI Divergence on Your Chart

Let’s take a closer look at an example using the USD/CHF pair on a 4-hour chart. In this chart, we can see both bullish and bearish RSI divergence signals.

Example of Bullish Divergence:

• Price Action: Price moves to a new low.
• RSI Action: RSI forms a higher low.

This type of divergence suggests that, although price is moving lower, the momentum is starting to shift, and the market may be poised for a reversal to the upside. In the chart, we’ve marked these bullish signals in green.

Result: The bullish divergence signal results in over 200 pips of profit before a basic overbought cross tells the trader to exit. This is a good example of how divergence can give you an edge over using basic RSI signals alone.

Example of Bearish Divergence:

• Price Action: Price moves to a new high.
• RSI Action: RSI forms a lower high.

In this case, the price continues to make new highs, but the RSI fails to confirm the move, indicating that the uptrend may be losing steam. We’ve marked these bearish signals in red.

Result: The bearish divergence signal occurs after a 50-pip rise, but the price ultimately declines by around 90 pips. This shows how divergence can help traders get in at a better price before the trend reverses.

The Advantages of RSI Divergence Over Basic RSI Signals

Let’s compare the performance of a basic RSI trader versus a divergence trader using the same USD/CHF example.

• Basic RSI Signals: The trader using basic RSI signals would have entered buy positions based on RSI crossing above 30 (the oversold level). However, these signals often led to losses, as the price would decline significantly before reversing. For example, the first buy signal leads to a loss of 250 pips, while the second buy signal results in a loss of around 115 pips. After these losses, the bullish divergence signal occurs at the actual market bottom, giving the RSI divergence trader a better entry point.
• RSI Divergence Signals: On the other hand, a trader using RSI divergence would have avoided these losing trades altogether. By waiting for the bullish divergence signal, the trader enters near the market bottom, capturing the full 200-pip profit from the uptrend before exiting. Similarly, the bearish divergence signal would have prompted the trader to go short at a better price, capturing the subsequent 90-pip decline.

The Takeaway: Why RSI Divergence Works

The key advantage of using RSI divergence is that it helps traders identify potential trend reversals earlier than they would with basic RSI signals alone. By waiting for divergence, traders can avoid many false signals and enter the market at a better price.

• Tighter Stops: With RSI divergence, traders can place tighter stop losses since they are entering at more optimal price levels, reducing risk.
• Improved Win Rate: Over time, divergence trading tends to yield better results than relying on basic RSI crosses. By waiting for the price and RSI to show a discrepancy, traders enter at more favourable points, increasing their chances of success.
• Leading Indicator: RSI often begins to trend before price does. This can give divergence traders a profitable head start, as they can enter trades earlier than those following basic price action alone.

RSI Divergence is a valuable tool for Forex traders looking to identify trend reversals or slowing momentum. By understanding the relationship between price action and the RSI, traders can make more informed decisions about when to enter and exit the market.

The biggest advantage of RSI divergence is that it allows traders to avoid false signals, enter at optimal price points, and place tighter stop losses for better risk management. When combined with other indicators or price action, RSI divergence can provide a solid foundation for a profitable trading strategy.