Understanding RSI Divergence: A Practical Approach

Today, we're examining the Relative Strength Index (RSI) on the EUR/USD daily chart, focusing on the concepts of overbought and oversold conditions.

I prefer to use divergence instead of absolute levels to determine overbought and oversold conditions. What is divergence? It occurs when the market reaches a new high, but the indicator does not, making a lower high instead. This suggests that the market is losing upward momentum.

In a downtrend, the opposite is true. If the market price hits a new low, but the indicator doesn't, it indicates a loss of downward momentum.

Let's look at some examples on the EUR/USD:
1. September 2023: The market hit a low of 1.0448, but the RSI did not reach a new low, signaling a loss of downward momentum. This suggested at least a correction, though in this case, the market actually reversed.
2. November 2023: The market reached a new high of 1.0960, but the RSI did not make a new high, showing a divergence. The RSI was at the same level as previous highs, indicating a loss of upward momentum.
3. December 2023: The market hit a high of 1.1139, but the oscillator didn't reach a new high, indicating a significant loss of upward momentum.
Textbooks often state that RSI levels above 70 are overbought and levels below 30 are oversold. However, in my 30 years as a technical analyst, I've found this isn't always accurate. Instead, you should determine overbought and oversold levels specific to the instrument you're analyzing. For EUR/USD, connecting peaks and troughs on the RSI chart shows that overbought levels are closer to 78, and oversold levels are nearer to 17, which are quite different from the standard 30/70 levels.

In summary, I find that looking for divergence works much better than relying on the absolute value of the RSI indicator.


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