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| RSI:
Bullish and Bearish Divergence |
In today's article I will discuss the many different
ways RSI can be used to make swing trading decisions. More specifically,
the first concept I will cover is bullish and bearish divergence.
On page 70 of New Concepts in Technical Analysis, Wilder comments
"When divergence begins to show up after a good directional move,
this is a very strong indication that a turning point is near.
Divergence is the single most indicative characteristic of the relative
strength line."
Bullish divergence occurs when a stock or index makes a low high in
price and the RSI indicator makes a higher low. Bearish divergence is
just the opposite -- price will make a new high, but RSI makes a lower
high. Typically, bearish divergence is marked by a rising trendline
above the price action and a falling trendline on the RSI indicator and
visa versa.
The reason this divergence occurs is built into the calculation of RSI.
As we saw last week, the formula divides the average up closes for a
period by the average down closes. Bearish divergence will usually occur
in the following manner. A stock will have a strong advance where the
average up closes sharply outweigh the down closes. A peak will then be
reached in both price and the RSI indicator. The stock will then have a
mild sell-off, or perhaps move sideways for a few days. When this
selling and consolidation occur, RSI will decline because the average
days up/average days down figure decreases.
Finally the stock again rallies and tests or slightly exceeds its
previous high. Because the RSI calculation includes the period of
decline and consolidation, it will be lower than the first RSI peak. The
opposite will hold true for bullish divergence. In visual terms, after a
strong directional move to the upside, traders should be suspicious of a
prolonged consolidation. Such a formation will always mark a period of
RSI deterioration. The opposite is true as well. After a sharp down
move, horizontal consolidation will lead to an improvement in the RSI
number.
RSI was designed by Wilder to anticipate price changes rather than
merely react to them. When the swing trader sees divergence, he or she
should become alert to the possibility of a significant reaction
or even a reversal in trend. It should be cautioned, however, that
bearish RSI divergence in itself is not a sell signal. The swing trader
should wait for a signal in price, such as a moving average crossover or
break of a trendline, before taking action. On the chart below, I have
used the 4- 9- and 18-day moving averages to provide a trading signal.
Under this system, a sell signal is given when the 4- and 9-day moving
averages cross below the 18-day after having been above them for a
sustained period.
The chart of Cognizant (CTSH) presents a good example of bearish
divergence. CTSH began a very strong rally near $27.50 at the end of
September. The RSI rally peak was November 17th, when the indicator
closed at 77.6 and the stock closed at $38.60. The stock then declined
for a few days before rallying. On November 26th, CTSH hit a closing
peak for this move of $39.19 and RSI finished the session at 72. This
was bearish divergence and warned the swing trader that a reaction or
reversal was in the works.
The bearish moving average crossover was completed in
early December near $37.50. Thus far, the stock has not deteriorated a
great deal, but both RSI and MACD say the stock should be avoided in the
short term.
RSI divergence is an important signal to spot. It tells
the swing that after a strong directional move, it is now time to nail
down profits. It can also sound the alert to go short after having been
long.
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