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 easily 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 active 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?
For example, this divergence in EURUSD:
How to trade RSI divergence with an automatic trading system?
My little tip is to apply two moving average (10 and 20 periods) to RSI and to 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 also have to use the same system with the price.
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 of time.
With this ADX filter, the indicator only shows the divergence when the ADX is bigger than 20.
As you can see, this time the range-market phases has much less false signals.
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