On the roads of Kuala Lumpur, Malaysia, the traffic appears chaotic. Many drivers don’t use indicators to signal their intention. As a foreigner you are left to guess what the cars in front of you are about to do next. When price flows in line with a trend it’s helpful to know, rather than guess, if a trend is about to turn.
An indicator I’ve been using more recently is the Relative Strength Index (RSI). The RSI is popular with traders who use it to seek out overbought territory when the indicator rises above 70 or oversold territory when the indicator falls below 30. It is also an oscillator, travelling between extreme highs and extreme lows.
In this article, I focus on spotting an opposite movement in price compared to the movement on the RSI, commonly known as divergence. It signals an early indication of a possible trend or price reversal. This divergence between price and RSI may make the difference between entering or exiting a trade.
General Rules
In an uptrend, Figure 1, join the dots between the highs above the price and the highs above the indicator.
Figure 1
In a downtrend, Figure 2, join the dots between the lows below the price and the lows below the indicator
Make sure the points line up vertically as shown by the blue dotted lines.
Figure 2
Trendlines matching the same direction on both the price and RSI indicator shows momentum in price travelling in the same direction. When the RSI trendline is drawn in the opposite direction to the price movements on the chart, we are alerted to a possible change in the previous price direction.
Regular Bullish Divergence in Downtrend
At the end of a downtrend, Figure 3, the divergence on the RSI signals a possible reversal. Price makes a lower low while the RSI oscillator makes a higher low.
It is a stronger signal if the first trough on the RSI starts below 30.
Figure 3
Bullish RSI Divergence - Double bottom, equal lows on price with higher low on oscillator
At the end of a downtrend, Figure 4, the divergence on the RSI signals a possible reversal. Price makes a double bottom low while the RSI oscillator makes a higher low.
It is a stronger signal if the first trough on the RSI starts below 30.
Figure 4
Regular Bearish Divergence in Uptrend
At the end of an uptrend, Figure 5, the divergence on the RSI signals a possible reversal. Price makes a higher high while the RSI oscillator makes a lower high.
It is a stronger signal if the first peak on the RSI starts above 70.
Figure 5
Bearish Divergence in Uptrend - Double top, equal highs on price with lower high on oscillator
Seen at the end of an uptrend, Figure 6, the divergence on the RSI signals a possible reversal. Price makes a double top high while the RSI oscillator makes a lower high.
It is a stronger signal if the first peak on the RSI starts above 70.
Figure 6
RSI Divergences are useful on any chart including stocks and FX.
The price moves in FX trading are fast and we never know exactly when the next pullback will occur. Watching the pips tick up makes me nervous about whether a small retracement is going to be the start of a significant reversal. I have found the RSI to be useful in assessing whether price has the potential to travel higher.
Using a past EURAUD trade, we observe divergences and how they interact with price and the GMMA.
Figure 7
On the EURAUD 4 hour chart, Figure 7, the short-term GMMA has passed up through the long-term and is signalling an uptrend.
Figure 8
The EURAUD 1 hour chart, Figure 8, shows a steady uptrend with widely separated lines in both the short-term GMMA and the long-term GMMA. Traders and investors were in full support of this uptrend.
A long position was opened at an entry price of 1.6130 with a Traders ATR stop loss of 1.6091 and a target profit of 1.6197 based on the calculation of 75% of the 5 day Average Daily Range.
Price moved up and I decided to close my trade, as marked by the yellow star, at 1.6156 for a profit of 25 pips.
Figure 9
On the EURAUD chart, Figure 9, price had made 3 continuous highs before the marked exit while the RSI printed above 70 at the first high then below 70 at the third high. A bearish RSI divergence had occurred.
This higher high on price accompanied by a lower high on the RSI led to price moving downwards for the next few hours.
Figure 10
Another area of interest on the EURAUD chart, Figure 10, occurred after the marked exit. Price made a double top of 2 equal highs while the RSI made a lower high signalling another bearish RSI divergence. Traders who did not exit at the first divergence had another opportunity to exit on the second divergence. Price continued lower still and the short-term GMMA fell through the long-term GMMA.
When another driver on the road signals an intention to turn left or right it is usually a reliable sign but we have to exercise caution in case it turns out to be a misinterpreted signal. RSI divergences are useful to traders as an indication of a possible turning point in a trend. It is not a standalone indicator and should be used together with other indicators in your analysis.