How To (AUTO) Trade Divergences
Today we would like to share with you a little tip: how to trade RSI divergence with an automatic trading system.
Divergence is a disagreement between a momentum indicator and price. Momentum indicators are the relative strength index (RSI), stochastics, and rate of change (ROC).
Generally, you can quickly discover the divergence with your eyes.
Fewer momentum signals something is changing. Maybe the trend reverses or consolidates.
Divergence in an uptrend occurs when price makes a higher high, but the indicator does not. In a downtrend, divergence occurs when price makes a lower low, but the indicator does not.
As a rule, this kind of analysis is great in a healthy trend market. So, when you identify a range-market, you could stop searching divergences.
In general, momentum indicators are useful in current trends, but it is useless in range-market phases.
Ok, It’s easy for human’s eyes to discover the divergence in a chart. But, how to figure out the divergence with an automated trading system?
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How to trade RSI divergence with an Automatic Trading System
Our little tip for you is to apply two moving average (10 and 20 periods) to RSI and Price.
When the price’s fast moving average is over the slow moving average, and the oscillator’s fast moving average is under the slow moving average, there is a divergence.
As you can see, the histogram follows the RSI direction.
You can use the same trick with the price. The Histogram follows the two Moving Averages.
When the fast-moving average is under the slow moving average, the histogram becomes red and vice-versa.
Now you have to put it all together and create an indicator that shows you only the RSI divergences.
Remember that the divergences don’t work in a range market. You could apply a trend filter to eliminate the false signals.
We can use the Average Directional Index (ADX). ADX is used to quantify trend strength. ADX calculations are based on a moving average of price range expansion over a given period.
With this ADX filter, the indicator only shows the divergence when the ADX is bigger than 20.
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