What is RSI Divergence?
This is when the Relative Strength Index indicator begins to reverse right before the price does.
Another way to look at RSI divergence is that RSI can display a change in price momentum, before you observe a change in price action. You can consider this as an early caution signal. In other words, it assist traders to detect likely price reversals.
The two main RSI Divergence are Bearish and Bullish Divergence
A bearish divergence comprises of an overbought RSI reading, followed by lower high on RSI. At the same instance, price must attain a higher high on the second peak, where the RSI is lower.
This can give you a clue that upward momentum is dwindling down and a downward move could be appearing soon.
As you would imagine, bullish divergence is just the inverse of bearish divergence.
In a bullish divergence scenario, there has to be an oversold situation on the RSI, followed by a higher low on the RSI graph. In that order, price must attain a lower low on the second peak.
What Does Divergence Tell You?
It majorly indicates negative and positive price movement along with any reversal if it is going to occur or not. Positive divergence exists when the price attains a new low, whereas the indicator attain a high. Similarly negative divergence occurs when the prices attain a new high, but indicator attain a low.
Positive and Negative Divergence in RSI
One can adopt the use of the Relative Strength Index (RSI) with the purpose of spotting positive and negative divergence in the price.
For instance, after plotting RSI on the price chart, if the price of the stock is moving up and attaining a high, whereas RSI is attaining a lower low, then one can consider it as a negative RSI.
Likewise, if the price of the stock is declining and attaining lower lows, whereas RSI is attaining higher high, then one can consider it as a positive RSI.
How Do You Confirm RSI Divergence?
The initial thing to note is that you cannot “confirm” any trading signal, in a way that would completely guarantee a profitable result.
It is expected that some new traders would think that there’s a way to be always certain of a winning trade. Well, that is simply not possible. Trading comprises of both wins and losses. However, you should take every possible step you can to ascertain that you have a legitimate divergence trading signal, before hopping on a trade.
Fortunately, there are only few variables that should be taken into account for a valid divergence signal.
The first thing to be on the lookout for in RSI divergence is a condition where RSI is in an overbought or oversold situation. This indicates that there exist a relatively extreme move and price is possibly going to bounce back from that mark.
Divergence Trading Strategy Optimization
Now that you have a knowledge of RSI divergence, let’s dive into a few ways to improve a divergence trading strategy. These strategies can guarantee an improvement in your win rate or average profit in a trade.
- Use Support and Resistance: you can multiply your chances of winning by looking for support and resistance marks that intersect with RSI Divergence. The trick is to look for a very clear support/resistance level.
- Trailing Exit: another way to increase your profits on a RSI Divergence trade is to trail your stop loss. As with any other trading strategy, switching your exit method does have trade-offs. When you begin using a trailing exit, your win rate might probably go down. On the long run however, trailing your stop loss can maximize your overall profits and you can likely automate your exits.
How do you trail your stop loss?
There are several ways to go about it but we will mention some common ones:
The first method is using parabolic SAR indicator. This is one of the most popular method. It prints dots above or beneath every candle.
If you don’t like the rigidity of the PSAR indicator, another method is to trail your stop is to move it to the next support or resistance level.
Fixed Profit Targets: if you don’t like the unpredictability of trailing profit targets, or targeting support/resistance levels, then fixed profit targets could be right for you.
A good place to start with fixed targets is to simply set take profit orders at risk multiple levels. This method is especially helpful if you find that you are frequently right about a price move, but then price retraces against you and you either get stopped out, or price hits breakeven.
When Does RSI Divergence Fail?
Just as with any other technical trading methodology, divergence will not work 100% of the time.
The most popular time when divergence fails, is in strongly trending markets. If you take way too much divergence trades in a strong trend, you are likely to lose a lot of money. And for this reason, be certain that you have a rigid money management plan in place.
Practice to figure out when you’re in a trend and have something like a 2-strikes policy, to curb your losses short.
Your win rate and percent return will also be deduced by your exit technique, the quality of your execution, and your skills to unbiasedly analyze your trades outcomes.
The most common reasons for the failure of any trading system are: not sufficient testing, giving up too soon, not recording your trades properly, the technique failing to have an edge, unrealistic expectations, not knowing your expected statistics, missing out on good trading chances.
Those are problems basically related to your trading psychology and trading process. Therefore, if you have a trading technique that has an edge and you’re on a losing streak, then it is time you looked at your process and psychology.
Don’t change methods simply because you have a losing streak. The problem might not be tied to your technique. Take a look at your elements of trading objectively.
The most common indicators for finding divergences are:
- Moving Average Convergence and Divergence
- Relative Strength Index (RSI)
- Commodity Channel Index
- William % R
Types of Divergences Patterns
Regular or Normal Divergences: are trend reversal signal and can be bullish or bearish.
Irregular or Hidden Divergences: are trend continuation signals and can as well be bullish or bearish.
Common Mistakes made by the trader while trading with divergences
A common error made by many novice traders while trading is the minute they observe the hidden RSI divergence, they place the trade accordingly. Both new traders and experienced traders need to be sure that the hidden RSI divergence is real and wait for future price action.
Remember that although divergence may look good in a few well-chosen examples, you need to have a complete, well-tested trading strategy so as to have long-term success with RSI divergence.
This begins with establishing a trading plan and back-testing your plan. Then if your technique passes those tests, you can move into beta testing. And if that succeeds, then you can move onto live trading. Take your time to go through this process.
If you rush yourself into live trading, you will likely rush out in a similar manner.