How to trade with RSI divergence indicator?

Definition

It is a technical indicator that identifies the divergence on the RSI line and then shows a trend reversal signal on the price chart.

Divergence is a term that means deviation between the price action and the technical indicator. For example, if the price increases, the indicator’s value should also increase, but they are doing the opposite. Technical traders use this divergence between price and indicator to determine the trend reversal. And the RSI divergence indicator automatically finds the divergence, and you don’t need to sit in front of the screen waiting for the divergence formation.

There are four major types of divergence in trading, and this indicator has made it easy to find out the divergence, and it will also alert you once a specific statement comes true.

Let’s talk about the different parameters of indicators, and then at the end, we’ll talk about the divergence trading strategy.

Formula

The RSI divergence indicator uses the simple relative strength index formula and then uses the custom codes to find the bullish and bearish divergence.

Relative strength is equal to the ratio of average gain to average loss.

Relative strength index = 100 – (100/1+relative strength)

Features

Besides identifying divergence, this indicator will also alert you automatically when a divergence forms on the price chart.

Trading strategy

According to expert traders, a retail trader shouldn’t wholly rely on technical indicators programmed for automation. It will be best to make a semi-manual trading system that includes humans’ and machines’ intelligence.

For example, you should use the indicator to do the rough work like divergence identification and then use your brain to make decisions like opening a sell/buy trade.

Let me explain to you with an example.

Here I am making a trading strategy using the candlestick pattern and the rsi divergence indicator.

Buy signal

When the indicator plots bullish divergence on the RSI line, it is a signal to open a buy trade. But before opening a buy trade, you must look for a bullish candlestick pattern. For example, if a pin bar or bullish engulfing pattern forms after the bullish divergence, then the probability of bullish trend reversal increases. Then at this point, you should open the buy trade.

The candlestick pattern will also allow you to set stop loss levels.

Sell signal

When the indicator plots a bearish divergence signal, you should not open sell trade immediately, but you should wait for the confluence of a bearish candlestick pattern. For example, if a bearish pin bar or engulfing candlestick forms after the bearish divergence, the probability of winning in sell trade increases. At this point, you should open a sell trade and add a stop loss level.

Backtest results of the RSI divergence indicator

I have attached the backtest results using the confluence of the RSI divergence indicator and candlestick patterns.

Total Backtested trade setups	16
Opened trades	8
Winning Trades	7
Losing Trades	1
Winning Ratio	86%

I found 16 trade setups using the rsi divergence indicator. Out of 16 trade setups, I could open eight trades successfully after filtering using the candlestick strategy. Of these successful trades, 7 were winning, and 1 was losing.

These backtest results will help you build a strong trading system using the RSI divergence indicator. 16 trade setups are not enough to build a strong strategy. You should gather the backtest results of at least 100 trade setups.

Here are the results of 16 trades in USDCHF:

MACD vs RSI divergence indicator

Both indicators, macd and rsi, can be used to find divergence. However, the histogram makes detecting divergence in macd divergence indicator easy.

Besides these two indicators, you can also use other oscillators for divergence, like the awesome oscillator, Aroon oscillator etc.

Summary

I always recommend traders build semi-manual trading systems. I don’t suggest entirely depending on the indicators because you’ll not become successful traders by following the indicators completely.

However, following price action and indicators can make you a successful trader.

Get access to access the RSI divergence indicator

Besides technical analysis, risk management is the most important term that you should also give proper time to build a risk management plan before trading.