very valuable piece of information.This failure of a hidden bullish divergence raises an interesting point. When astrong indication that something is supposed to occur (in this case, prices were to "rally")and the market does the opposite of what it "should," a longer timeframe has entered thegame. In effect, you are seeing and feeling the force of a longer timeframe.The Bears pushed prices lower to 1 0 1 A08 before allowing the prices to rally fortwo bars before pushing prices to a new low close at 1 0 1 A07 making a 4 period bullishdivergence. Going into the close ofthe trading day, the Bulls managed to rally prices toa close of l O l A 1 2. A trader who held overnight positions could have gone short on theclose as prices made a MDRP DOWN with a downside target of 1 0 1 A02.When the market opened the next morning, it gapped lower. The Bulls ranprices up to close the gap and almost generated another MDRP DOWN (it would havebeen a MDRP DOWN if the look-back period was 9 instead of 14) before selling themarket to push prices lower to a low close of 1 00A24. The downside target from thesecond MDRP DOWN had been met. Prices rallied until the RSI ran into resistance at60 with a close of 1 0 1 A04.At this time, we had a long- term MDRP DOWN giving us a downside target of1 00A20. Entering a limit order for 1 0 1 A04 would have gotten us short and our stop wouldhave been a tick above the high at 1 0 1 A07. Price action proceeded to make a hiddenbearish divergence, followed immediately by a hidden bullish divergence, and anotherhidden bearish divergence. This is highly unusual - it is a witness to the struggle be­tween the Bulls and the Bears, which the Bears won as they were the last ones to makea meaningful pattern. Prices collapsed to 1 00A 1 5. The RSI made a low of22.94 beforemaking a bullish divergence with the close of 1 OOA 1 5.End of chart # 1 9 notes.79
John HaydenDRAwlNG TRE DUNES BASED ON MOMENTUM DISCREPANCY REVERSAL POINTS
Looking at Charts # 1 8 and # 1 9, you can see that trendlines can be drawn basedon the RSI and Momentum Discrepancy Reversal Points. In Chart # 1 8, we used theupper parallel trendline as our exit point. As mentioned before, there are many method­ologies used to draw trendlines. By taking our knowledge of Momentum DiscrepancyReversal Points, we can then draw very accurate and significant trendlines.In an ideal world, a trendline represents either a floor (support) or a ceiling(resistance) that prices will only negate when the trend has actually changed. Thereason that many traders are leery of entering a trade based on a trendline is becausethey do not know how to draw statistically significant trendlines. When a trendline isdrawn using the RSI in junction with a Momentum Discrepancy Reversal Point, the"reliability" of the trendline is significantly increased.To draw an up trendline, we would look for a "locked in" MDRP UP. Then, wewould draw the trendline from the close of the reference point (on the left) to the closeof the MDRP UP (on the right) and extend the line to the right.As a general rule, we are only concerned with where the close is in relationshipto the trendline. This means that if prices are falling toward an up trendline, we wouldexpect the Bulls to defend the trendline keeping the Bears from closing the bar belowthe trend line. Should the Bears close the bar below the up trendline, the trend is injeopardy. Should the bar go below the trendline with the close being above it, we wouldnot consider the uptrend to be in danger of failing.As the timeframe of a chart increases, the significance of "N" closes under theup trendline increases. If we have drawn an up trendline based on an MDRP UP andthe upside target has not been hit, the Bears closing the price below this line on a 5minute chart is considerably less significant than if the trendline was drawn on a dailychart. The analogy is the same for the reliability of an MDRP UP or MDRP DOWN;a longer timeframe has more power and significance.When a "locked in" Momentum Discrepancy Reversal Point is generated, atrendline using the correlated closing points can be drawn. Should this line be negatedby a closing price, an early indication is given that the price target will NOT be met.When this occurs, we can exit the trade or move the protective stop.
80
CHAPTER 6
TREND DIRECTION USING MOMENTUMDISCREPANCY REVERSAL POINTSWhen a Momentum Discrepancy Reversal Down (MDRP DOWN) forms, weknow that the preceding trend has been down. We also know that prices are currentlyexperiencing a retracement higher, if the prior trend was valid then the contra-trendretracement should end and the dominant trend should reassert itself. Momentum Dis­crepancy Reversals Down only occur in downtrends and Momentum Discrepancy Re­versals Up only occur in uptrends. When we see one of these reversal patterns, weinstantly know the probable trend direction.DETERMINING TARGET LEVELS
When we see a Momentum Discrepancy Reversal Point, we can easily deter­mine the upside or downside target that prices should hit. In fact, prices must hit thetarget if the preceding trend is still intact. These target prices are significant numbers.If the target price is NOT exceeded on a c/osi1'Jg basis, then the market is telling usthat the current trend is finished.Upon seeing an MDRP UP, the upside target can be determined by obtainingthe difference in price that coincides with the prior RSI trough and the current price.This difference is added to the intervening high close price giving us the upside target.The process is the same for determining downside target objectives. To determine anupside target, obtain the price that coincides with the two RSI troughs and add it to thehighest close between these two troughs. To determine the downside target, obtain theclosing price that coincides with the two RSI peaks and subtract this difference from thelowest close between these two peaks. These concepts were illustrated and previouslydiscussed in the notes for Charts # 1 7, # 1 8 and # 1 9 .
81
John HaydenTHE MOST POWERFUL REVERSAL SIGNALS
The most powerful reversal signals occur when multiple timeframes with simul­taneous reversal signals point in the same direction. If a 5-minute chart shows a Mo­mentum Discrepancy Reversal Up, and a 30-minute chart simultaneously has a tenta­tive Momentum Discrepancy Reversal Up, we have a very strong indication that thecoming up move will be explosive. The Momentum Discrepancy Reversal Point signalbecomes more significant as the length of the timeframe increases.The second most powerful Momentum Discrepancy Reversal Point signal oc­curs when the time interval between the peaks or troughs is less than 5 bars. However,even long time intervals can result in powerful moves. Typically, if the time interval ismore than 5 bars, we would like to see a price retracement that is less than 38.2%. Thisprovides a very good indication that we will have a good up move and that the targetprice will be achieved. As the retracement level becomes deeper and the time periodincreases, it becomes less likely that the target price will be hit.Of the many uses of the RSI, the MDRP Up or Down Reversals are the mostpowerful and profitable. The reversal signals tell us the direction of the trend, NOW isthe time to enter the trade and the target price so we know where to exit the trade. Bytaking note of the corresponding price of the "locked in" MDRP UP or MDRP DOWN,we have a key price to work with. We also have another key price when we calculatethe upside or downside target level.Rule # 4An Uptrend is indicated when:1 . RSI is in the 80/40 range2. The chart shows simple bearish divergence3. The chart shows Hidden bullish divergence4. The chart shows Momentum Discrepancy Reversal UpA Downtrend is indicated when:1 . RSI is in the 60/20 range2. The chart shows simple bullish divergences.3. The chart shows Hidden bearish divergence4. The chart shows Momentum Discrepancy Reversal Down.
82
CHAPTER 7
THE RELATIONSHIP BETWEEN PRICE & RSI RETRACEMENTSAs previously discussed, retracement moves are the result of traders becomingtoo emotional and pushing prices either too high or too low. When they realize thatprices have been pushed to "hysterical levels," a contra-trend move commences whereprices reverse and retrace some of the preceding move. The percentage that pricesretrace a prior move is dependent upon the strength of the preceding trend, which isdetermined by the perception of the dominant traders.We know that shallow retracements are less than 33%. Shallow retracementsare a good indication that prices should extend higher by the same degree of the priormove. We also know that longer timeframe traders are either ignoring or agreeing withthe price action, as the contra-trend move was less than 33% of the prior trend.If a retracement of a rally in a 5-minute chart is hitting the 33% retracementlevel, and IF the 5-minute Bulls are in charge AND the longer timeframe traders (saythe 1 5-minute traders) are asleep or in agreement with the prior rally, then we should seeprices reverse higher now. The upside target is the same distance as the initial rallywhen calculated from the 33% retracement level. This was illustrated on page 26 inTable #9 of Section I.We can use a similar line of reasoning with some modification when observingRSI behavior. Often, the RSI will show a shallow, medium, or deep retracement moredistinctly than a price chart. We are not able to establish upside or downside targetobjectives using RSI retracement theory as we can with price retracement theory. Forexample, if the RSI rallies from 35 to 75, which is a move of 40 RSI points. If the RSIretraces 1 3 points to a value of 62, we know the retracement is shallow. Should there beno other timeframes in disagreement the RSI should rally to exceed its previous high.Unlike price, we cannot add 40 to 62 to obtain the upside RSI target of 1 02 because theRSI behaves as a logarithmic function with a maximum value of 1 00.83
John Hayden
When attempting to combine price retracement theory with RSI retracementtheory, we encounter some difficulties because the RSI can more easily overextenditself than price. This over-extension creates reversal formations such as MDRP UPand MDRP DOWN. Let's look at what typically happens when the RSI is not overex­tending itself.Because the RSI is very sensitive to the movement of price especially in the 40to 60 zone, it will usually retrace a larger percentage of its prior move than price. Inother words, if price is retracing 33%, the RSI will often retrace 50 to 60%.Rules # 5
-
General Rules of Retracements - Combined
Price Retracement
RSI Retracement
No more than 85.41%r-- 1 25% ofprevious leg up
approx. 1 25%6 1 .80010 to 85.41 %6 1 .80010 to 85.41%
r-- 125% of previous leg dowr
MeaningMomentum Discrepancy Reversal PointBull DivergenceBear Divergence
We want to see a shallow price retracement coincide with a MDRP UP orMDRP DOWN. This provides two strong indications that the original trend will re­assert itself with a shallow retracement and a Momentum Discrepancy Reversal Point.However, as the depth of the price retracement increases, the market is telling us thattraders in a longer time frame believe that the preceding trend was false, which givesthem an opportunity to fade it. Should there be a "tentative" MDRP UP or MDRPDOWN concurrent with a medium or deep retracement, we should become cautious.As the percentage of the price retracement becomes deeper, the probability of achiev­ing the target level obtained from the MDRP UP or MDRP DOWN begins to decrease.However, considering how the different timeframes interrelate, there are plenty oftimes,even with a deep retracement, that an MDRP UP or MDRP DOWN will easily surpassits upside or downside target level.
84
CHAPTER 8
IDENTIFYING SUPPORT AND RESISTANT PRICE LEVELSWe know that these are the 5 key numbers in order of importance:The price where a Momentum Discrepancy Reversal Point is madeThe upside or downside price target of a Momentum Discrepancy ReversalPoint3. The price where a basic retracement reverses (pag�s 1 8-20)4. The price where a divergence occurs (using the right shoulder)
1.2.
Now we have the ability to precisely identify important price levels, which al­lows us to set our stop levels. In the event they are hit, the trend has probably reversedor weakened so much that prices are about to stagnate. In either case, we really shouldno longer be in the trade.Conventional knowledge states that the RSI chart is helpful in revealing certainprice behaviors that are not so easily seen on a price chart. This is absolutely true onceyou understand the key numbers! At this point, you should have a thorough understand­ing of the RSI and be able to identify these important support and resistance levels.The most important number is the Momentum Discrepancy Reversal Point price.Since the RSI is calculated on the closing price of a bar, stops can be placed tighter thanusing the low or high price. When day trading, I like to place stops 2 or 3 ticks awayfrom these key prices. Since the charting application I use gives me the ability to entertext directly onto the chart, I enter the key numbers directly under the RSI patterns.This makes it very easy to identify key numbers and their locations.
85
John HaydenCHART # 20 - TRADING CHART WITH PRICES ON RSI
..
ufg.rT·'· oo,ngShort1 '08 iI. �;, NII",hr _.
RSlw Zon.-cIOM,14,40.80) 38,31,
T_l0'22.o1 '1101 JV
t,oeOI
�3ihT-T3i27·'TH·r;o.;"'-·r4Ai"--r��o"-�1'1--t;Ul8T'14m··f�·1·�t--"'-i.(i�--r-�"f·*·r�·t-�-;r-·T'"oIFT-"·i·5I22.,-ITM9-'+TSifI-t-"T�·r-'&io"T--re.llir"Te;18T···T�,-r·-t• .....ltipl. auIt OIv. Expac: ••
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Notes for Chart #20:
This is a chart that I use in trading. The only modification I made replacing theCandlesticks with bars for ease of printing. Since I use TradeStation™ Charting byOmega Research and Epsilon Charting, I have the ability to type the price just above thepeak or trough on the RSI plus any comments I might have. I use the following colorscheme:1 . Gray for bear or bull divergence.2. Green for MDRP UP3. Red for MDRP DOWN4. Black for normal priceI also enter the target levels as T= "n" and any swing point greater than 1 as"s2," "s3" and so on depending upon strength. The colors used in the trendlines are thesame as above.
86
RSI: The Complete Guide
On the far left of the chart is a bearish divergence at 1 1 72. 1 8 telling us that themarket trend was UP. Prices fell to 1 142.07 on March 25, which was below the supportlevel at 40 RSI. At this point, we were not sure if the trend had definitely shifted, as itcould have been nothing more than the 1 30-minute Bears and smaller timeframe tradersbecoming too pessimistic pushing prices lower before a timeframe longer than 1 30 min­utes begins to buy. We don't have to wait long as prices rally to 1 1 50. 1 9 creating aMDRP DOWN. We know that the Bears have once again re-asserted themselves atthis point. They confirm their strength by closing prices below the downside target of1 1 38. 1 7 at 1 1 34.85 just 3 bars later! After studying the RSI to this point, you should beable to place a piece of paper over the price action and tell by the RSI chart everythingwe originally set out to accomplish as outlined on page 4 in Section I.End chart # 20 notes.
87
88
CHAPTER 9
HELP! A LONGER TIMEFRAME JUMPED IN My PUDDLE !We know that the marketplace consists of traders who focus the majority oftheir energies on different timeframes primarily because of their level of capitalization.At times, different timeframes will be the reason for the underlying price momentum.The concept of trading in different timeframes is a very difficult concept to fully under­stand and is considerably beyond the scope of this book. For the purposes ofthis book,all we need to understand is when the timeframe we are focusing on has been takenover (permanently or temporarily) by a different timeframe.This is easy to determine using Momentum Discrepancy Reversal Points anddivergence. For example, if we see that prices are steadily falling on a 30-minute S&Pchart. Then, we see a small contra-trend rally of less than 32% before the market onceagain falls to new lows. This decline is followed by another contra-trend rally. This timethe contra-trend move rallies almost 50% on the price chart and 1 05% on the RSI chartgiving us an MDRP DOWN. Once again prices eventually fall and exceed the targetedlow. This is a good example of a solid bear market that is controlled primarily by the 30minute traders in agreement with shorter and longer-term traders - i.e., prices and RSIperform as expected.However, what happens if the 450-minute traders decide that the move downshould be faded because they think prices are going higher without letting the 30-minutetraders know? These traders begin to buy on weakness to reduce slippage. This meansthat we will see the formation of multiple bullish divergences. More importantly, themarket will be unable to achieve the targeted lows created by any future MDRP DOWN!Without knowing that it is the 450-minute traders who are fading our 30-minute bearparty, we must as 30-minute traders recognize the clues. There are simple and multipledivergences and failed MDRP DOWN targets. Upon recognizing the clues, we can
89
John Hayden
either exit our short positions or tighten our stops until we are stopped out of our posi­tions. When the 30-rninute timeframe traders are once again in charge, we can re-enterthe marketplace in the direction of the 30-minute chart.If we are interested in aligning our trade position with the dominant traders, wemust examine multiple timeframes until we find a time frame where the price behaviorbecomes crystal clear. In our example, once we look at a 450-minute chart, we mightdiscover that the reason the 450-minute traders faded the 30-minute bear market wasbecause there was a MDRP UP or perhaps even a long-term bear divergence on the450-minute chart!In summary, we know that longer timeframe traders have decided to enter thegame when what should be working - fails. The market is indicating something signifi­cant when there is a "high probability expectation" that fails. You must be payingattention at all times. We can also identify when shorter timeframe traders have de­cided to play because they are the ones that create the MDRP UP and MDRP DOWNformations. They are also the reason that the 60 and 40 levels are slightly exceeded ina bear or bull market respectively.
90
CHAPTER 1 0
CONCLUSIONNow we have a working model of how price and RSI behave and relate. Wehave also discussed why there are different timeframe traders and how these tradersinterrelate with each other. We have studied basic retracement theory, the differenttypes of divergences and their meanings and Momentum Discrepancy Reversal Points.To successfully use everything requires a trader to have a thorough understand­ing of the underlying principles. The foundation of this working model is the mathemat­ics ofthe RSI calculation and Fibonacci ratios. The mathematics tells us that there is acertain zone where the RSI is most comfortable. It is in this zone that very slightchanges in price are easily magnified, and RSI values where price changes barely movethe RSI value. The Fibonacci number sequence allows us to identify percentageretracement levels that will help us identify the strength or weakness of a precedingtrend.The real nature of the marketplace is one where any two traders can agreeupon a price and this price can be valid or invalid depending upon whether one traderwas "forced" to trade. In this case, the information that the "trade price" conveys isworthless. We learned that because of the different capitalization levels of traders, notall traders are focused on the same interval of time. We also know that simple diver­gences are a good way to quickly determine the trend and when we see a divergence,we should begin looking for a place to fade the coming contra-trend move.Often, the place or price to fade this retracement move is when we see anMDRP DOWN or MDRP UP in the RSI that coincides with a shallow to mediumretracement in price. Once we have a "tentative" MDRP UP or MDRP DOWN, wecan determine the upside or downside price target. Once this MDRP DOWN or UP
91
John Hayden
becomes "locked in," we have a valid support or resistance price that we can be usedfor our stop placement. Using the targeted upside or downside price, we have a place toconfidently take some or all of our profits.If the targeted price is not reached, the trend is probably about to end. An earlyindication that the price objective is in danger is the negation of a corresponding trendlineon a closing basis by one or more bars depending upon the timeframe being used. Wealso know that we can determine when longer-term timeframe traders are present be­cause the targeted level is not achieved and/or we begin seeing multiple signal diver­gences. We can also detect short-term traders because they typically create the MDRPUP and MDRP DOWN formations and cause the 40 support and 60 resistance levels tooccasionally be exceeded in bull and bear markets. By identifying the prices that createthe RSI patterns, we are able to use those price levels as stops allowing us to captureadditional profits. Here is a summary of everything:TREND DETERMINATION TABLEUptrend
Downtrend
RSI ranges from 80/40Simple Bearish DivergenceHidden Bullish DivergenceMomentum Discrepancy Reversal Up
1.2.3.4.
5. Upside Targets being hit.6. 9 bar simple moving average is greaterthan the 45 bar exponential movingaverage on RSI7. Contra-trend declines do not exceed50% of previous rally
5.6.
1.2.3.4.
92
7.
RSI ranges from 60/20Simple Bullish DivergenceHidden Bearish DivergenceMomentum DiscrepancyReversal DownDownside Targets being hit.9 bar simple moving average!is less than the 45 bar exponential moving average on RSIContra-trends rallies do notexceed 50% of previousdecline
RSl: The Complete Guide
TREND IN DANGER TABLEUptrend in Danger
Downtrend in Danger
1 . Longer Timeframe fading rally1 . Longer timeframe fading decline2. a. Multiple long-term bearish divergences 2. a. Multiple long-term bullishdivergences.b. Upside targets not being hit.b. Uoside tare:ets not beine: hit.3 . 9 bar simple moving average less3 . 9 bar simple moving averagethan the 45 bar exponential movinggreater than the 45 bar exponenaverae:e on RSItial movine: averae:e on RSI4. Hidden Bearish Divergence, or simple4. Hidden Bullish Divergence, orBullish Divergencesimple Bearish Divergence5. Deep contra-trend retracements5 . Deep contra-trend retracements
93
94
DayI
Close
U8u.471 3 80.42
Change
Advance
Decline
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2
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4
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6
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7
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8
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=IF(OR( C I O<O,C I O=O),ABS(C I 0),0)=IF(OR(C I I <O,C I I =O),ABS(C I I ),O)
AvgGain
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Close
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ABS(F 1 6/G 1 6)
IS
1 382. 1 8
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=«G 1 6 * 1 3)+E 1 7)/14
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=
16
1 382.22
=B I 8-B 1 7
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17
1 382. 1 2
=B I 9-B I 8
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18
1 382.36
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19
1 382.32
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20
1 382.22
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