(Originally published 7/29/2011)
This post is part of a multipart series. If you wish to start at the beginning go to Taking RSI to the Next Level
Every trader at some point deals with divergences as they learn technical analysis. Divergence is a very generic term and can be applied to any two datasets, but most divergences are considered a warning sign to the prevailing trend. It is a basic and simple rule of Technical Analysis. When using divergences, more often than not people are talking about divergence of price from a momentum indicator like the MACD, RSI or any of the many to choose from. But when we are discussing divergences with RSI there is more to the story. Bullish and bearish divergences on RSI are a sign of a loss of momentum in the current trend; however, further study showed that in most cases these divergences are not necessarily a warning for the end of the trend, but more so for the potential end of the immediate leg you are in. One of the big problems that technicians have with divergences is identifying which one to act on. Once you have the rest of the RSI toolkit with the concept of Range Shifts and Positive/Negative reversals you start can use them with divergences to help identify THE divergence which can add a powerful edge to your positioning.
With RSI charts Andrew realized that divergences more often work as detours to a trend than they do reversal of the trend. Of course some trends end with a divergence (more often in a downtrend), but which divergence? It is really hard to tell alone, but when combined with the other nuances we have learned about RSI it gets a little easier. For day traders and swing traders divergences if caught correctly can certainly be profitable, but for trend traders and position traders RSI divergences need to be looked at a little differently. I have marked up all the charts the same I have the entire series. The $MS chart below gives a good example having many divergences to choose from.
When looking through the RSI charts you will notice that more often than not you see a bearish divergence show up in a bull range (notice in all the charts) often starting in the 70-80 range and proceeding down with lower highs in the RSI while seeing higher highs in price. So if we reverse that, bullish divergences show up in bear ranges often starting to form with an RSI low in the 20-30 range. Since downtrends tend to be faster and cover ground quicker than in up trends you will not see as many divergences before THE divergence shows up, but the concept still works.
As we can see with $EQR, in a strong uptrend you can have many bearish divergences in a row as prices march the trend forward with higher highs and higher lows. These swings can be very tight in a strong trend or can be wide and loose but still making higher lows as the trend continues. As I stated earlier, divergences can have good profit potential very short term, and if you pick the right one it could be a full trend reversal. So let’s go through signs we can look for to see if we have the right one.
One of the first things I would look for is if the bullish or bearish divergence to fall into a positive or negative reversal. $EQR shows multiple positive reversals on the chart. This would be my first clue of a head fake because if I see a positive reversal per say, then the trend is innocent until proven guilty with a failed pattern. We already know that a failed positive or negative reversal is a warning signal so combining it with a bearish divergence give two clues of a trend change.
When $EQR was showing bearish divergences the immediate pullback often will bottom with the RSI well above 40 and fire a positive reversal which we already know is a sign of trend confirmation. If you buy when the positive reversal appears, then you have a very well defined stop loss and target that will give you confirmation of a good entry. As long as that positive reversal reaches its target, the trend is still up and the bearish divergence was nothing more than a pause in the trend that gave a good opportunity to get in or add more to a strong trend with a reasonable risk.
Now we will look at the downtrend in $HPQ which you don’t get as clean or as many signals. What you do get is plenty of bullish divergences that rise into negative reversals that could have been very profitable.
The other important thing to look for is where the RSI terminates on the next swing after the divergence bottoms. It is usually not until the RSI tops out right around the 60 range that you are more likely to see a change in the trend (back to the range rules). Traditional RSI analysis says that when RSI can’t get back above the normal overbought zone at 70 then you have a failure swing. With Andrew’s work 70 is a level to look at, but we know the more important level is 60 due to the range rules. Therefore, if we get a peak below at or below 60 (or trough at or above 40) in the RSI whether it is a divergence or not we should pay attention. I have marked many of these failure swings on the charts above, but we can see in the IWM below that we have both signals showing. One in the beginning of the chart and a negative swings through the chart. We also get a good reminder that not all signals work as the markets started to chop sideways, but they were worth watching closely. Also realize it looks like we may be getting some failure signals here as I write this, but it will take another day or two to confirm.
The charts above show how we can take our RSI toolkit and add it to common divergences on the RSI to help narrow down the ones we actually take. Of course none of these tell you to buy or sell at the exact turning point, but most get you in or out in a very reasonable area if the trend is changing. They are also very good at telling you when it is not which is just as important. In the next piece I will talk about how size does matter especially for faster traders. So all you day and swing traders stay tuned.
Good Luck, it is there for the making!
(All market data above are derived from Stockcharts.com, Esignal, and Reutersdatalink)
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There is no guarantee that the views expressed in this communication will become reality. Investing in the stock market involves risk and potential loss of principal, Investment strategies should be thoroughly researched and understood before implementing and none of this should be construed as a recommendation