RSI Divergence Forex Trading Strategy

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RSI Divergence Forex Trading Strategy

The Relative Strength Index (RSI) is one of the more popular indicators among traders, and it is definitely worth its fame. Let’s take a look into how the RSI works and more importantly how we could use it to improve our trading results.

The RSI – What is it?

The RSI is basically a momentum based oscillating indicator developed by Welles Wilder. It measures the average of the gains or losses over a specified number of candles or periods. It then plots the figures on a separate window, oscillating up and down a specific range. With the right parameters, it somehow characteristically mimics price action closely, close enough that it also shows sharp peaks and troughs.

This jagged characteristic that emphasizes peaks and troughs is one of the strengths of the RSI. Because of this, turning points on the price chart also coincide with many of the peaks and troughs on the RSI chart. However, there are times when the depth or height of the troughs and peaks differ between the RSI and the price chart. This is what we call divergence.

Another important feature that the RSI has is that because it is plotted on a fixed range, it is able to draw a line where we could say that price could be overbought or oversold. This feature is very helpful for traders who are looking to enter on reversals or are trading mean reversion strategies. This is because these types of market are prime conditions for reversals.

What is Divergence?

Divergence is essentially the disagreement between the price chart and an oscillating indicator. This is noticeable when the height or depth of the peaks and troughs on the price chart differs with the peaks and troughs on the oscillating indicator.

For example, normally when the price chart is making higher highs and higher lows, the peaks and troughs on the oscillating indicator should also be printing higher highs and lows. In the event that the oscillating indicator print a lower high or low when the price chart is still printing higher highs and lows, that would be a divergence.

Divergence are usually found prior to a sharp reversal or thrust. This makes divergence trading a prime strategy to enter on reversals.

Below is a cheat sheet for divergences.

rsi divergence forex trading strategy 01

Trading Strategy Concept

This strategy is about the confluence of divergence trading and the overbought or oversold market conditions. This will further be improved by observing for price patterns or candlestick patterns that indicate a probable reversal.

To trade this strategy, the trader should have an adequate knowledge of candlestick patterns or price patterns and should sufficiently identify divergences. This is quite an advanced skill for most newbie traders but could be learnt with sufficient practice.

To aid us in our quest for pips, we will be using the ZigZag indicator. This is not the main indicator for this strategy but is more of a training wheel to help traders identify swing highs and lows. These swing highs and lows should usually coincide with the peaks and troughs on the RSI window.

We will then wait for the RSI to move to an overextended market condition, either overbought or oversold. Once this happens, we then observe for divergences or if a divergence would develop at the next peak or trough.

These divergences should also coincide with a reversal candlestick pattern (pin bar, engulfing patterns, etc.) or better yet also with a price pattern (double tops, head and shoulders, etc.). We then trade these setups as soon as it develops.

Indicator

  • ZigZag Indicator: Depth = 5
  • RSI: Period = 10

Currency Pair: any

Timeframe: any

Trading Session: any

Buy (Long) Trade Setup Rules

Entry

  • A trough on the RSI should have visited the oversold area below 30
  • A bullish divergence should be observable
  • A bullish candlestick pattern or price pattern should be observable
  • Enter a buy market order at the close of the candle which forms the pattern

Stop Loss

  • Set the stop loss at the swing low below the entry candle

Take Profit

  • Option 1: Set the take profit at 2x the risk
  • Option 2: Set the target take profit at a recent swing high

rsi divergence forex trading strategy 02

rsi divergence forex trading strategy 03

Sell (Short) Trade Setup Rules

Entry

  • A peak on the RSI should have visited the overbought area above 70
  • A bearish divergence should be observable
  • A bearish candlestick pattern or price pattern should be observable
  • Enter a sell market order at the close of the candle which forms the pattern

Stop Loss

  • Set the stop loss at the swing high above the entry candle

Take Profit

  • Option 1: Set the take profit at 2x the risk
  • Option 2: Set the target take profit at a recent swing low

rsi divergence forex trading strategy 04

rsi divergence forex trading strategy 05

Conclusion

This is a strategy that many professional traders use. However, this type of strategy is not one that could be automatic. It is still considered a discretionary type of trading because identifying divergences and price patterns are mostly subjective. It is up to the trader to correctly identify these things. As your skill in identifying candlestick patterns, price patterns, and divergences develop, your accuracy should also develop along with it. You could even take off your training wheels – the ZigZag indicator.

Regarding the exit options, this could also be discretionary. For setups where the swing points are either too far away or are too close to the entry point, we could opt to have the take profit at twice the risk. It locks in the right reward-risk ratio, however I feel that the swing points are the more logical target areas as these are natural support or resistances.

Practice this strategy until you become proficient at it.

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