RSI in the stock market: How to leverage this oscillator and its divergences for trading

The RSI indicator is one of the most widely used tools in stock technical analysis to detect extreme market conditions. Trading divergence with RSI, in particular, represents a signal of considerable importance that can anticipate trend changes with good accuracy. However, like any oscillator, it requires complementing with other analysis methodologies to avoid false signals.

Fundamentals: What is RSI in the stock market?

The ‘Relative Strength Index’ or Relative Strength Index is an oscillator that measures the magnitude of bullish movements versus bearish movements over a specified period. Its main strengths lie in two aspects:

Smoothing of extreme variations: Reduces noise generated by erratic price movements.

Normalized scale (0-100): Provides a constant fluctuation band that allows evaluating the relative position of the price objectively.

Mathematical calculation of RSI

The indicator formula is:

RSIn = 100 - [100 / (1 + RSn)]

Where RSn is the relative strength for n periods, calculated by dividing the average of bullish closes by the average of bearish closes. This quotient is normalized within the 0-100 scale.

Typically, a 14-period parameter is used, although it can be adjusted according to the specific trading strategy.

Interpretation of the RSI indicator: Overbought and oversold

The RSI indicator in the stock market is fully leveraged when it reaches extreme zones. Basic interpretations are:

Overbought zone (≥70): Suggests that the asset has experienced aggressive buying and could be near a bearish correction. However, in strong bullish trends, it can remain in this zone for extended periods.

Oversold zone (≤30): Indicates intensive selling conditions that could precede a bullish rebound. Similarly, assets with weak fundamentals can stay here indefinitely.

Mid level (50): This invisible but crucial level serves to validate trend continuation. When RSI oscillates between 50 and 70 in an uptrend, or between 50 and 30 in a downtrend, it confirms the dominant direction of movement.

Trend validation with the mid level

Consider the case of Meta Platforms (NASDAQ: META). In March 2020, the RSI touched oversold, generating a price rebound. As long as the oscillator remained fluctuating between the overbought zone and the 50 level, the uptrend was consolidating. Multiple overbought points between June and August 2021 did not invalidate the trend as long as the price did not break its previous line and RSI did not cross into oversold. The break occurred in February 2022, confirming the change of direction. From that moment, as long as the indicator did not surpass the mid zone, it was considered minor corrections within the dominant downtrend.

Buy and sell signals based on RSI

Buy signal

Opening long positions requires three simultaneous conditions:

1. RSI reaches oversold (below 30)
2. The oscillator returns and stabilizes within the fluctuation band
3. The previous downtrend line is broken

Taiwan Semiconductor Manufacturing (NYSE: TSM) offered this setup between September and October 2022. The indicator remained in oversold, then recovered, and finally the price broke the downtrend line developing since January 2022, generating a clear entry signal.

Sell signal

Short positions are confirmed when:

1. RSI reaches overbought (above 70)
2. The oscillator retreats to the fluctuation band
3. The previous uptrend line is broken

Applied Materials Inc. (NASDAQ: AMAT) exemplifies this pattern. Between November 2020 and April 2021, the indicator remained overbought during the strong uptrend. Subsequently, the oscillator retreated while the price formed a lateral range. In January 2022, after several months, the uptrend was broken and the price began to fall steadily, confirming the short entry signal.

Trading divergence: The most powerful tool of RSI

When turning points of the price coincide with those of RSI, it is called convergence, which confirms the existing momentum. Divergences, on the other hand, occur when these points diverge and often anticipate significant changes in direction.

Bullish divergence

Occurs during a downtrend when:

• The price forms increasingly lower lows
• RSI forms increasingly higher lows

This setup indicates that, although prices are falling, buying pressure is gaining strength, anticipating a bullish reversal.

Broadcom (NASDAQ: AVGO) clearly showed this pattern. The price chart showed decreasing lows, but RSI was developing higher lows, signaling that demand was strengthening. The bullish reversal was later confirmed, consolidating over the next two months.

Bearish divergence

Emerge during an uptrend when:

• The price forms increasingly higher highs
• RSI forms increasingly lower highs

This scenario warns of losing upward momentum and anticipates a bearish reversal.

Walt Disney (NYSE: DIS) provided a textual example. While the price was developing higher highs, the RSI reflected lower highs. This divergence captured market weakening and correctly anticipated the bearish reversal, which remained valid for more than a year afterward.

Combining RSI with other indicators: RSI-MACD

The RSI indicator in the stock market can generate false signals, especially on shorter timeframes. Combining it with MACD (Moving Average Convergence Divergence) strengthens the decision-making system.

The MACD consists of three components: MACD line, SIGNAL line, and histogram oscillating around level 0.

RSI-MACD operational system

The conditions to identify entries and exits are:

1. Necessary condition: RSI reaches overbought or oversold
2. Technical confirmation: RSI retreats to the fluctuation band
3. Sufficient condition: MACD line crosses the histogram’s midline in the opposite direction of the previous trend
4. Trade closure: MACD line crosses the SIGNAL line in the opposite direction

In Block Inc. (NYSE: SQ), a situation of overbought was observed indicating a potential end to the uptrend. When RSI retreated to the fluctuation band and MACD line crossed downward the histogram’s midline, a bearish trend was confirmed, allowing a short position to be opened. The trade remained open until MACD crossed upward over the SIGNAL line, which occurred approximately four months later in March 2022.

Conclusion

The RSI indicator in the stock market, when combined with trend analysis and complemented with other oscillators like MACD, offers a robust methodology for trading markets. Trading divergences, in particular, represent powerful signals that every technical analyst should master. The key is not to rely solely on these indicators but to use them as confirmation of patterns identified in prior trend analysis.