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 at a glance with a simple observation.
The increased divergence between momentum indicators and price 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 works better in a healthy trending market. So, when you identify a range-bound market, you should stop searching for divergences.
In general, momentum indicators are useful in identifying current trends but are useless in range-market phases.
While it is relatively easy for human being’s eyes to discover the divergence in a chart; however, here, we focus on how to identify the divergence with an automated trading system?
How to trade RSI divergence with an Automatic Trading System
The insight we provide here will enable you 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 method 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 exclusively identify you only the RSI divergences.
Remember that the divergences do not work in range-bound markets. You could apply a trend filter to eliminate the false signals.
For this purpose, 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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