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and that you may want to take partial profits on your long position, since the price may be about to take a price detour. It is not telling you to get short! |
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A divergence takes a certain number of time periods to form. The strength of a divergence is based on this period of time. The probability is that the price will retrace some of its prior move increases as the strength of the divergence increases. A divergence that has a period of 5 will be a lot stronger than a 20-period divergence. Here's how to calculate the period of a divergence. Let's say that prices have been advancing (on a daily chart) over the past few weeks, and the price and the RSI are both making new highs, as we can see in Figure 16-6. For the next two days the price and the RSI both drop (points b and c), then the price and the RSI reverse and rally (point d) for one day followed by a drop in price and the RSI (point e). This decline is followed by a two-day rally (points f and g). At the close of the second day (point g) of this short rally, the price is higher than it was six days earlier (point a), yet the RSI is under its previous peak. This is a six-day bearish divergence. When looking at a chart, place an X at the RSI high (point a), then start counting the number of days it took for the RSI to "hook" over and drop. You then get the number of days that the divergence signal took to form. This is important to know, since a six-day divergence is usually indicative of a detour in price. The longer-period divergences usually indicate a lower probability of a price detour coming. The most powerful divergence is a 2- or 3-period divergence. In the overall context of using the RSI in trading, the divergence signals are relatively minor. I like using divergence to give me a clue of what the overall trend is and where to take partial profits in a multiple-contract position. |
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Another tool I use to indicate trend is the old workhorse of technicians, moving averages. Moving averages are valuable, since they remove the volatility from the calculations. By using a moving average based on a 14-period RSI, you are effectively removing the volatility of the last 14 days, yielding a smoother signal. I like using a 9-period simple moving average, and a 45-period weighted moving average. I calculate a simple 9-period moving average and a 45-period weighted moving average on the closing price and on the RSI value. This results in four moving averages, and by using them together, I can confirm the trend. In this way I can quickly determine which of the four operating modes the market is in. Figure 16-5 shows how the different moving averages interact with each other. |
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1. When the 9-period moving average based on price is above its respective 45-period moving average, and the 9-period moving average based on the RSI is above the 45-period based on RSI, the trend is Up (at points b and d in Figure 16-5). |
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