This acceleration is reflected in the RSI. The RSI value fallsbelow 40, below 33.33, then below 30. At this point from our previous study ofthe ratios, we know that the ratio of average loss to average gain is badlyextended. As the RSI moves lower, it is encountering increasing mathematicalresistance. Remember that the RSI is a logarithmic line and for it to movelower when it is below the 30 level is much more difficult than when it was at50.Third. As prices continue to fall, one or two things will happen. The moreperceptive traders in the existing timeframe realize that prices are becomingoverextended. These are the traders who got short early in the decline. Theybegin buying to exit their positions and help to slow the plunge. As the plungeslows, the somewhat less perceptive traders also realize that prices are overex­tended and they also begin to exit, which typically stops the decline. Concur­rently, traders in a longer timeframe may have realized that prices are too lowand step in with their buy orders. As soon as the plunge stops and prices beginto rally, even the dumb (but not proud) traders realize that the plunge is over andbegin buying propelling prices higher.What was the cause for prices to accelerate downward in the first place? Theanswer to this question is simple; there were no buyers in the market. In order for thesell "at market" orders to be filled, someone had to be willing to buy. If there are manysell orders and no buyers, then prices can only go down. If there are no sell or buyorders entering the pit, prices will stagnate.In any case, prices stop declining and begin to rally at some point. Just as an airbubble expands in size as it ascends in liquid, the RSI expands upward as it moves upfrom its extremely compressed state at the 30 or lower level. This is ordained because66
RSI: The Complete Guide
of its mathematical formula. As prices rally, there will be traders who begin to think thatprices are "too" high and begin to sell; pushing prices lower thereby making new lows.Because the RSI uses a ratio of average gain to average loss over "N" periodsof time, it will be forced lower, but at a lesser rate than its previous rate of increase.Consequently, we will see a new low price, but the RSI value will not see a lower valuethan its previous low. This is a divergence between price and the RSI. At some point,the Bulls will overpower the Bears and the market will see another rally. Because theRSI value is so compressed, it will begin to increase its acceleration higher. As the RSIrises from levels below 30 towards 40, it begins to incrementally increase more than theprice increases, giving the illusion of a new low.The important question is, "Did the RSI rally above the 66.7 level or moregenerally the 60 level?" If not - the trend is still down. Let me ask you, "When does abullish divergence make its appearance on the RSI chart?" The answer is only whenprices have been declining. If divergence is considered within the context oftrend, whatis the existing trend when we see a bullish divergence? A downtrend! What can weuse as an indication that the trend is down? We know we are in a downtrend when wesee a bullish divergence. This is why in the above Intel chart there are no Bullish Diver­gences - the market is trending higher, NOT lower!I realize that the published trading literature states that a bullish divergence is anindication that prices are about to rally. The "implication" is that a bullish divergence isan indication that an uptrend is about to commence. As you are now realizing, a bullishdivergence only appears when the existing trend is down. If the trend is clearly down,why are we even thinking of buying? Wouldn't it be more prudent to be looking for aplace to get short?A bullish divergence signifies that the existing trend is down and the Bears areexhausted. We should be expecting a rally to sell into. Ifwe have short positions, thenwe should exit some or all ofthe shorts, but not reverse to become long! Prices shouldrally or reverse to some degree before falling to new lows.Inversely, when we see a bearish divergence, the trend is up and we shouldprobably expect a retracement to lower prices because the Bulls are exhausted. It istime that we should begin looking for a reason to buy.A simple divergence means that prices have encountered enough resistancethat they need time to consolidate their previous move. Once this has occurred. priceswill resume their downward or upward march.
67
John Hayden
The price that generated the divergence often becomes a key number used toidentify temporary support or resistance. Once this price is negated, it becomes aresistance or support point and can be used for a stop price.CHART 14-DIVERGENCE PRICE BECOMING FUTURE RESISTANCE OR SUPPORTES2�0�09 Lt-ST- 3 min Ofl<Et2D02. . .. . . . . . . . . . .;. .
. . . . . . . . . ! : . . . . . . . . . -: . . . ..
. .. .. :�. . . . . . . . . . , . .
. . . . . . . l ; · · ..
1 0()5. 00
. .
.. . .. . . .(
1 000.00.
.
.
.
.
.
�-':�': �'::J� 995.00
: :,
t
.. -:c:- � , L.j. '---1 - > - - --- - � - ---.. +: -. - - - �.; Et .. ., .-�. :'-.', . . . . . , , . . . . ... .- : ----- " --- --"'� - -- --.f'd" now r�ance " 7': ". � � �
" '9 "
-
--
-
..
• .
.
.
-. , ·. .•
.
.
.
. . .
." . " .,-
'd"is � :
. • . • . . . • . . ; . • • ' . . . • . ;.
-- - - -
. . . . . . . . ,:. . . . . . . . .. � . . . . . . . . . . j ' . . . . . . . . ; . . . . . • . . . •'. • . . • • . . . . . ) . •
985.00
. . . . .. 980.00
"" ",.! . . . . . . . . . ; . .. . .. . . . .,.. . . . . . , . . , . . . . . .
975.00
A.80.0Q..70,00 .
. 5:15
5:42
S:09
7:30
1 0: 1 2
7:5'7
1 0:39
1 1 :OS
H :33
1 2:00
Chart 14 Notes:
This chart contains 2 bullish divergence and one bearish divergence. The pricewhere the divergence was made became future support/resistance. Remember thatsupport once negated often becomes resistance and vice versa.The strength of a divergence formation can be determined by observing thenumber of time bars that have elapsed between the RSI peaks and troughs that arecreating the divergence. This is called Divergence Strength and is a method that is usedto rank divergence as strong or weak. Generally, if the number of time intervals is lessthan 4, then there is strength in the divergence and an immediate retracement shouldoccur. As the number of time intervals increases, the likelihood of a retracement de­creases. In Chart # 1 4, from point C to point A there are 6 bars. This is called a 6 period68
RSI: The Complete GuideBearish Divergence and is not very potent. In the Intel Chart # 1 3 the interval is indi­cated by 'N'p.As the time interval between the RSI peaks and troughs increases, the likeli­hood ofseeing multiple divergences also increases. Multiple bearish divergences occurwhen there are successively higher price rallies while the RSI has successive lowerrally highs. Here is the paradox of divergences; simple divergence provides a strongindication that the preceding trend will resume as soon as the retracement is completed.But, multiple long-term divergences increase the likelihood that the preceding trend hasended. This concept is illustrated below in Chart # 1 5.CHART # 15
-
LONG-TERM MULTIPLE BULLISH DIVERGENCE
In Chart # 1 5, there are three bullish divergences where the price has madethree consecutive lower lows while the RSI made three consecutive higher lows. Thesehigher bullish divergences would be classified as multiple long-term bullish divergences.They are indicating that there is an increasing probability of a trend reversal occurring.69
John Hayden
The most powerful divergence signals are called hidden divergences. They arecalled hidden divergences because they are not obvious to the untrained trader. Thesedivergences do not occur at the bottom or top of the RSI chart like their more commoncousins. They appear after the RSI has either rallied (bullish hidden divergence) or afterthe RSI has dropped from its high (bearish hidden divergence). Hidden divergencetypically occurs in the 40 to 60 ranges. When hidden divergence occurs, it is classifiedas the strongest divergence possible. The market will do exactly as the name indicates.A hidden bullish divergence is a very strong indication that prices are about to stronglyrally. Put another way, a hidden bullish divergence that appears in a bear market is astrong indication that the trend is about to reverse. \ Chart # 1 6 shows hidden bullishdivergence. You can also see a 3p Hidden Bear Divergence in Chart # 1 3 of Intel.CHART # 16
-
HIDDEN BULLISH DIVERGENCE1 1 60 001 1 4 0 001 1 20 001 1 00 00
1080 00
106<100
t·
4 52 1 1
'611 4
'6I11 - ·...... �1 30
[111 1111 [11
1-
104000
1021) 00
100000
·7000
'6f1Q
In Chart # 1 6 Note a hidden bullish divergence showed up beneath the 30 levelafter a 9 period simple bullish divergence. Immediately after forming the pattern, priceshad a significant bear rally. Notice that the Bears stopped the advance when the RSIvalue approached 60.70
RSI: The Complete Guide
Building a chart that combines a 9 period RSI and a 9 period Stochastic Indica­tor (slow) is a method that can be used to identify strong multiple divergences indicatingstrong contra-trend retracements or possible trend reversals. The exact pattern that weare looking for is three or more simultaneous long-term divergences in the RSI andStochastic charts. When this occurs, you not only exit your position but reverse posi­tions by taking a smaller than normal position 1 or 2 ticks above the high or low of thesecond peak or trough.CHART # 17 - RSI & STOCHASTIC WITH 3 SIMULTANEOUS BULL DIVERGENCESlNDX LAST·S min
' .'
. . ·11�1 ·· "
I·
'
0612&11001 C:=1021 24 ·96 1 0 ·8 55" 0:979.87 H= 1 03S!i3 L:919 &7..V:.O. ...
.
..
1'1 'III .
/1.. 1' '\I'llI,lL :,. '1'I 1III
1 3 1 0.00
.
1 300.00
1290 00
Ii
\1'lt�" :I :,.
:. 'III1 ,1.'i "'·�II','·"II'H'" III I .,'· 'R....•II'--�' ritt'-,---:;;ltr-t �---,-'------+__-'-'"'tYtt!lr---ir_ _:r+:___�+__'_c-
s " u s··.· �'I u":""II!.
1 2 5 0 00
.
1240.00
1 00.00
Chart #17 Notes:
In the RSI, we have mUltiple medium term bullish divergences at: 1 (against thereference point) and 3 (using 4 as a reference point). We have long-term multipledivergences at: 2, 3, and 5 all against the reference point. Point # 4 is not a long-termmultiple divergence as it is not under #3 and above the reference point. In the SlowStochastic, we have medium term bullish divergences at 1 (against the reference point),2 (using 1 as a reference point) and 3 (using 2 as a reference point. We have multiplelong-term divergences at 2, 4, and 5 (all against the reference point). Point #3 is not along-term bullish divergence for the same reason #4 in the RSI was not.71
John HaydenI added some information to this chart regarding MDRP DOWN signals.We will discuss these signals in the next section. What is noteworthy is that wewere able to project downside targets that were eventually hit. This entire time,we did not see any bearish divergences and the RSI stayed under 60. I markedthe chart showing when the Bulls were able to gain control when they were ableto push the RSI above 60. Also, take note of the semi-hidden bullish signal on
May 23, 2002 around 11 :30.
We can see how the price that coincides with the
divergence point often becomes future support or resistance, which will be use­ful with our stop placement.
End of Chart # 1 7 Notes.As in life, there are exceptions to every rule. With the exception of three ormore long-term bearishlbullish divergences and hidden divergences, the appearance ofa simple divergence is a very strong indication that the trend is opposite of what thename implies. When a simple divergence is encountered, the only trade strategy thatcan be employed is to exit some (or all) of the trade position. Once prices begin toretrace the preceding trend and a contra-trend move or retracement is seen, the pricethat coincides with the RSI peak or trough becomes a key price. This price will oftenprove to be temporary support/resistance once the preceding trend re-asserts itself.Once the price has negated this temporary support, this price area may be used as astop.Rule # 3 :An Uptrend i s indicated when:1 . RSI values remain in an 80/40 range2. The chart exhibits simple bearish divergence3 . Hidden bullish divergence are seenA Downtrend is indicated when:1 . RSI values remain in a 60/20 range2. The chart exhibits simple bullish divergence3 . Hidden bearish divergence i s seen
72
RSI: The Complete Guide
CHAPTER S
MOMENTUM DISCREPANCY REVERSAL POINTSThe RSI behaves at times in a manner that indicates prices have retraced partof their preceding move too quickly. When this occurs, the shorter timeframe tradershave overextended themselves in the retracement. If prices on a 5-minute chart wererallying in a strong uptrend and the 5-minute traders became overextended, prices wouldbegin retracing some of the prior move in a contra-trend r�tracement to the down side.However, as prices headed lower, they would become overextended because of the 1 minute timeframe traders. Since the RSI is a very sensitive momentum based indicator,it has the ability to detect these hysterical overextended retracements.When the RSI retracement exceeds the previous peak or trough and price hasnot exceeded its previous peak or trough, this is called a Momentum Discrepancy Re­versal Point. Andrew Cardwell discovered this pattern and has taught many tradershow to recognize and implement this pattern into their overall trading strategy.MOMENTUM DlSCREPANCY REVERSAL Up - MDRP UP FOR THE BULLS!
This pattern only occurs when the Bulls are pushing prices higher in a bullishtrend. Occasionally, prices will retrace some of the previous rally, while staying above aprior price trough. The RSI simultaneously retraces beyond a previous RSI troughwhere the price that coincides with this RSI trough is lower than the current price. Thisis a Momentum Discrepancy Reversal Up (MDRP UP). Described another way, aMomentum Discrepancy Reversal Up (MDRP UP) occurs when the RSI value is lowerthan a prior RSI trough, and the price is higher. Until the RSI "hooks up," the formationis a "tentative" MDRP UP. Once the RSI has hooked to the upside, the formation is a"locked in" MDRP UP. The price that coincides with this trough is a significant price.Chart # 1 8 illustrates this concept:
73
John HaydenCHART # 1 8
-
MOMENTUM DISCREPANCY REVERSAL POINT Up
..0.005:36
5:51
6:06
6:11
6:36
6:51
7'06
1:21
7:36
7 51
8:06
8:21
8:36
8;51
9:06
11:21
Chart # 1 8 Notes:
This is a 3-minute chart of the E-Mini S&P 500 from June 26, 2002. Early in thetrading day, the market was bearish because the RSI value was under 40. There was asmall rally and resistance was encountered at RSI 40 value. Normally, this is a goodindication that the market is about to get hammered. In this case, the market made a 3period bullish divergence at 8:39. When the cash market opened at 9:30, the Bulls madea small opening gap pushing prices higher, negating the RSI 60 level. At this point, weknow that the trend has probably changed to UP. We receive confirmation of this whenthe RSI retraces lower and finds support at 60 (#1 on the RSI chart and the "Ref' baron the price chart). The ensuing rally found prices at point "A" before retracing lowerto point "B" on the price chart. At this point, we see that the RSI value is lower at point"B" than at point "A," but the price is higher. This formation is a Momentum Discrep­ancy Reversal Up (MDRP UP).
74
RSI: The Complete Guide
We can calculate the strength by determining the number of bars precedingpoint "B." In this case, it is an 8 period MDRP UP, which is a medium strong signal.Like the strength indication of a divergence signal, the strongest Momentum Discrep­ancy Reversal Point signals are 2 to 4 periods in length. A medium strength signal is 5to 1 5 time periods and a weak signal is anything over 1 6 time periods. We can alsocalculate the upside target by obtaining the difference between points "B" and "Ref'and adding the difference to point "A."(956.00 - 953.75) + 963 .0
=
965.25
The next question that arises is where do we get long? We must consider ourrisk to reward ratio that we ideally want to be a minimum of 1 :3. Since the close of bar"B" was 956.0 and our upside target is 965 .25, our potential profit is 9.25 points. Tomaintain our risk to reward ratio, we must risk no more than 3.0 points. My preferenceis to not risk more than one point on a 3 minute S&P trade. We need to find a point toexit the trade in the event the Momentum Discrepancy Reversal Up fails. Carefulexamination of the chart shows that the high for the "Ref' bar was 955 .25 and the lowof bars " 1 " and "B" were both 955.00. This would be a double bottom in a timeframethat is smaller than 3 minutes. We can surmise that the Bulls will probably protect955 .00, so our stop can be placed at 954.75 . Since we are trading in a 3-minute timewindow, the odds of using a limit order, which is the preferred method, to enter the tradeare not very good because of the double bottom. Because of this, we should enter a"buy at market" order, which will get us long at approximately 956.00 with a stop placedat 954.75 .We could have entered one bar earlier at bar " 1 " because with the close of bar" 1 ," we had a MDRP UP which can be seen by carefully looking at the RSI chart. Seehow the downward slant changes just before the ultimate low? If we had observed this,we could have entered a buy limit order at 955.25 with a stop placed at 954.75 . Thereason that the low was made in bar " 1 " was because the traders in a smaller time framesaw the high at 955.25, which was resistance at that time. When that point was ne­gated, it should become support. The traders in the smaller timeframe entered their buyorders at 955.25. With the close above the previous close in bar "C," the formation is a"locked in" MDRP UP. We can move our stop to 955.75, which is a tick below the closeof956.00.At this point, we are long and want to maximize our profits on this trade. Theupside target for this trade is 965.25. Prices rally to a high of 964.5 closing on the highof the bar, which is a bullish sign. In the next bar, prices collapse and the high is the sameas the open, which is a very bearish sign. Prices were within 0.75 points of our target.With the collapse in prices, we have a bear divergence, making two medium term diver75
John Hayden
gences. We do not have a long-tenn bearish divergence as the RSI at (#4) is not above(#2) and below the RSI peak.Since prices must close at or above the target to confInn the bull market, we should besomewhat nervous about ever seeing a profIt. The Bears push prices down to a low of956.75 before the Bulls begin to buy again. Our stop is still at 955.75 and we are stilllong the market. As the Bulls begin to push prices higher, we begin trailing our stophigher. Why didn't we trail our stop earlier? When we entered the trade, all indicationswere that prices were headed higher. Once we begin trailing our protective stop, theprobability of being stopped out in a minor retracement increases. So we wait for thefIrst minor retracement before moving our initial stop.The reason that we began using a trailing stop is because prices should havereached our target and didn't! With the close on bar "D," we have confIrmation that theBulls are going to push prices higher. How do we know this? "D" is the fIrst bar sincethe low of956.75 where the Bulls managed to close a 3-minute bar above the high of thepreceding bar. After the close of "D," we can move our stop from 955.75 to 956.50,which is one tick below the low. This is not much, but every little bit helps. The Bullsonce again rally prices before faltering and retracing to "E". The next bar after "E" seesthe Bulls closing the bar above the high of bar "E" confInning the validity ofthe Bullsintentions and the swing point low of "E." We can move our stop from 956.50 to 958.75.The Bulls rally prices to our target price of 965.25. The price just touches itbefore closing under it at bar "F." In all probability, our sell limit order of956.25 wouldnot have been fIlled. However, three bars later at bar "G," the Bulls extend prices to justabove 965.25 before closing the bar out under it. With bar "H," we fInally achieved ourupside target of 965.25 ! With bar "G" pushing prices just above 965 .25, we could haveexited our trade with a "sell 965.25 or better" order. If our position had only one lot, thatis what we should have done. If our position had multiple contracts, we should haveexited 50% of our trades and kept the rest of the position in case the trade turned into abig winner.Assuming that we had multiple positions, we would be long with the close ofbar"H." We need to move our trailing stop to just under the latest swing low at bar "G."The price level for the stop is 962.75. Naturally, the Bulls encounter resistance after thenext bar after "H." We had an idea that there would be resistance at this level becausethere was a fairly large upper shadow in "H." Prices retrace lower in the next two barsmaking a low at "I" before rallying again. With the second bar after "I," we can moveour stop from 962.75 to 966.00.The question that naturally arises is "Where do we exit our remaining position?"Previously, we discussed that trendlines on the RSI chart are as strong as trendlines on76
RSI: The Complete Guide
the price chart. The problem with drawing trendlines on price charts is that their place­ment is largely subjective. Ask 1 00 technical analysts to draw trendlines on the samechart and you will get 1 00 different trendlines! By using the RSI, very accurate trendlinescan be drawn. We can draw a valid trendline whenever we can identify a MomentumDiscrepancy Reversal Point. In Chart # 1 8, we have the bottom trendline, which isbased on the Close of the "Ref' bar and the Close of bar "B." After drawing thistrendline, we can draw a parallel trendline and place it on the highest Close between thereference and end bar of the Momentum Discrepancy Reversal Point pattern. You cansee this bar in Chart # 1 8. We will discuss RSI and MRDP point based trendlines onpage 80.When prices rallied to the upper trendline at bar "K," we should have exited ourremaining position. Should you have kept one contract ''just in case" prices continued ontheir rocket trajectory, you should have exited the last contract when the swing low point"I" was negated 2 bars after "I." Additional emphasis should have been placed onexiting the remainder of the position when the upper trendline was negated because wewere also seeing a very bearish long-term divergence in the RSI and multiple long-termbear divergences in the Stochastic indicator that is not shown.End of Chart # 1 8 comments.MOMENTUM DISCREPANCY REVERSAL DOWN - MDRP DOWN FOR THE BEARS!
A Momentum Discrepancy Reversal Down (MDRP DOWN) is the exact in­verse of an MDRP UP. However, I will describe it in a slightly different way to aid inclarity. As prices fall, there will be the occasional bares) that closes higher than theprevious bar causing the RSI to generate various lower peaks. As more traders becomeconvinced that prices will continue to fall, the plunging prices slow. before reversinghigher in a contra-trend rally. After all, if everybody has sold, who will continue to hit thebuyers lower bids? If the bids are not being hit, then prices are unable to fall. In anycase, as prices begin to rally so does the RSI. For every instance, where there was aclose higher than the previous bar in the preceding downward plunge, the RSI alsorallied. This gives the RSI the appearance of a jagged downward sloping line. If youremember, successive lower peaks and troughs indicate a bear market.The RSI rallies as prices begin their contra-trend retracement higher. As theRSI rallies, the RSI value exceeds one of these previous RSI peaks and should the pricethat created the previous RSI peak be lower than the current price, we are seeing a"tentative" MDRP DOWN. Once the price drops and hooks the RSI down forming apeak in the RSI indicator, we have a "locked in" MDRP DOWN. This locked in MDRPDOWN gives us a si�ificant price that coincides with the peak. Chart # 1 9 illustratesthis principle.77
John Hayden
CHART # 1 9
-
MOMENTUM DISCREPANCY REVERSA L DOWN
10.00
40.00
850--�g:)O-- 1 O:10-1O:5iil1:'3012:1O-12:50��--""9:30 -':'=0:1-:-. -:-=:-':-:-:::::--':" :-:-:-':-;;-;:- -=:Range Sh� 10 EEl;;;r (,mjer 4�1
30.00
Chart # 1 9 Notes:
This chart is the September 2002 30-year T-Bond futures contract. The T­,Bonds rallied to make a high close of 1 0 1 "27, shortly before 10:50. As it was making ahigh close, the RSI was generating multiple short-term bearish divergences and onelong-term bearish divergence. A bearish divergence indicated that the trend was up, butthe multiple bearish divergences told us that the trend was in danger of failing. With theclose of 1 0 1 " 1 7 at Noon, the RSI negated the support level at 40 indicating that theuptrend was "probably over." The following rally to a close of 1 0 1 "24 while the RSIstayed below 60 generated a Momentum Discrepancy Reversal Down with a downsidetarget of 1 0 1 " 16. The math for this calculation is:
Since an MDRP DOWN only occurs in a bear market, we already knowthat the trend is down. The MDRP DOWN has a period of 1 9, which makes it is aweak signal. Attempting to enter the market on a limit order would not have worked78
RSI: The Complete Guide
because after closing on the high, prices gapped lower opening the next bar at the low ofthe previous bar. For this reason, a market order was required. For the shorter intra­day timeframe, market orders must be used when trading with Momentum DiscrepancyReversal Points. As the timeframe expands to 30 minutes and daily bars, limit ordersshould be used for market entry.Prices fell for the next two bars to Bar "e." The close at C was l O l A 1 5 , whichwas under our downside target allowing us to exit our trade and confirming the downtrend.The next bar closed up at l O l A 1 8 and then the market fell for 2 bars, closed unchangedthe next bar and rallied to make a hidden bull divergence. This formation should havebeen a very bullish indication, but the next bar closed below the divergence price giving 'us a valuable clue as to how serious the Bears were about taking prices lower. It isimportant to remember that when a "probable" price behavior is immediately negated,the market has just provided a