A bearish divergence occurs when prices continue to form higher highs (typical in a bull market) while your oscillator (in this case an RSI) is forming significantly lower highs (indicating weakness in the trend.)
A bullish divergence occurs when prices fall to a new low while an oscillator fails to reach a new low.
The relative strength index (RSI) is a momentum oscillator indicator developed by
J. Welles Wilder Jr. measures the speed and change of price movement. It evaluates the oversold and overbought conditions in the price of an asset by oscillating between two extremes that have a reading from 0 to 100.
Traditionally, the reading below level 30 is considered an oversold signal, and a reading above the 70 level is considered an overbought signal.
RSI overbought and oversold strategy is a great tool to pick the tops and the bottoms of a currency pair, which could help to eliminate wrong entries. For example, it can avoid entries at the wrong places, such as buying on the top and selling at the bottom.
Like many momentum oscillators, overbought and oversold readings for RSI work best when prices move sideways within a range.
One can also add a centerline level of 50 to the RSI, between 0 to 100 levels. The centerline level could help to check the price momentum for any change in the direction of the trend.
For example, If RSI is above 50, momentum is considered up, and traders can look for opportunities to buy the market. Below is an example on USD/JPY; when the RSI passes above 50, notice that the price starts gaining momentum and pushes upward.
On the other hand, a drop below 50 would indicate that price is losing momentum, which could be a development of a new bearish market trend and an opportunity to sell as is illustrated below.
The opposite of the bearish divergence has happened in the USD/JPY chart below. Here notice that the price is making a lower low, while the indicator is doing the opposite by making a higher high. The bullish divergence signals that the indicator does not follow the price and does not confirm the lower low. Thus, as it can be seen, the price starts gaining momentum right after.
A straightforward strategy could be developed based on the overbought and oversold strategy together with the center-line signal. For example, buy when the RSI passes above 50 and exit when it enters the overbought zone (above 70). Sell when it passes below 50 and exit the sell when it enters the oversold zone (below 30).
However, for this strategy to work effectively, you must have a well-tuned RSI and confirm the signals in conjunction with other indicators for a better result.
The default period of the RSI is 14; however, one can tune the period according to the market condition. The longer the period, the smoother is the RSI (Oscillator) to the changes in the price, and the shorter is the period, the more responsive the RSI is to the recent changes in the price.
A shorter period RSI would generate more signals in general than a smoother one and more false signals as a result.
Besides the oversold and overbought signals, RSI can also generate signals by looking for divergences and failure swings.
Disagreement between the price and the indicator is called divergence. Divergence is an effective strategy that can spot potential market reversals by comparing the indicator and price direction. Typically RSI will follow the price, if there is a price decline, RSI also declines, and if there is a rise, RSI also rises. Thus, divergence occurs when the price acts independently from the indicator, and the price and the indicator begin heading in two different directions.
Bullish divergence happens when the underlying currency pair makes a lower low and RSI forms a higher low. This signals that the indicator does not confirm the lower low; as a result, it could be interpreted that the price is gaining momentum. Conversely, a bearish divergence occurs when the underlying currency pair makes a higher high and RSI forms a lower high. In this case, RSI does not confirm the new high, which could be considered weakening momentum.
For a better illustration, below, You can see a bearish and bullish divergence on NZD/CHF and USD/JPY, respectively.
On the NZD/CHF chart below, it can be seen that the RSI does not follow the price. The price is making a higher high, while the indicator is singling a lower low. This is considered a bearish divergence, where the indicator does not confirm the new high, and the price starts losing momentum right after the divergence.