Trading Forex: Divergences Using RSI

Filed under: Learn Forex Trading |

As I briefly discussed the use of divergences in today’s trade example article, I would like to run through the ins and outs of divergences in a little more detail during this second article. So let’s get right to it…

 

Figure 1.

If you take a look at Figure 1, you will see some good examples of divergences using an RSI (Relative Strength Index) indicator. This is an indicator (which should not be confused with ‘Relative Strength’, which is different) that shows the strength or weakness of a forex pair (or stock). It is a momentum oscillator and it is based on the closing prices only.

 

However, other than using RSI to get a quantitative measure of the strength of the market, we can also use it to look for divergences. A ‘divergence’ is when the RSI does not do what the forex pair is doing. In figure 1, the pair makes new lows but the RSI does not, signalling that a change of market sentiment is about to occur. And indeed it does. Then, the market makes a new high, but the RSI indicator moves down. This again, signals another change in market sentiment, and again, the tip-off would have proved to be correct.

 

Now, this will not work every time, and in fact, no single methodology or technique will work every time. However, it is a good strong signal to tell us that there might be a change in market sentiment imminent. These signals might not be strong enough to initiate a contrarian trade, as the change in market sentiment can be lagging. However, the signals could be strong enough for us to exit a trade or to refrain from taking a trade that we might otherwise take. In summary, RSI divergences are a useful tool to have in our trading arsenal, and it is something that you should perhaps look at before taking any trade.

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