Divergences are also an extension of the Dow Theory rule of non confirmation between indices. DOW Theory looks for non confirmation between two indices. While divergence looks for non confirmation between price and its RSI. Unlike failure swings, divergences are a bit loosely defined. There are simple and complex divergences. There are also divergence failures and divergence loops. As a basic guideline, whether divergences are able to create a trend reversal or not they do create some weakness in the ongoing trend. Fig 1. illustrates a bearish divergence and Fig 2. illustrates a bullish divergence.

The next issue of Interpreting RSI we will speak about the following aspects.

4. Price Patterns on RSI
5. Trendline on RSI
6. Reversal Techniques on RSI
7. Channeling on RSI
8. The 40 and the 60 line on RSI
9. Moving average on RSI
10. Changing RSI default values from 14

[bold]RSI calculation[/bold]

For each day an upward change or downward change amount is calculated. On an up day, i.e. today’s close higher than yesterday’s:

Upward change = close today − close yesterday
Downward change = 0
Or conversely on a down day (Downward change is a positive number),
Upward change = 0
Downward change = close yesterday − close today

If today’s close is the same as yesterday’s close, both Upward change and Downward change are zero. An average of Upward change is calculated with an exponential moving average using a given N-days smoothing factor, and likewise for Downward change. The ratio of those averages is the Relative Strength,
RS = Exponential MA of Upward change / Exponential MA of Downward change

The index is then formed by using the formula:

RSI = 100 - ((100/1+RS))

The RSI fluctuates within a band of 0 to 100. Oversold and overbought lines are traditionally drawn at 30 and 70 levels. Wilder originally used a 14 day period for smoothing, but 7 and 9 days are commonly used to trade the short cycle and 21 or 25 days for the intermediate cycle. Cycle interpretation helps to decide the period for RSI. The RSI should confirm price movement; therefore, if the stock price is moving up, the RSI should be moving up as well.

If prices make new highs and also the RSI indicator makes new peaks then there is no technical weakness. But if prices make new highs and RSI indicator fails to confirm this, i.e. make lower highs, a negative divergence is given indicating the weakening of the technical structure. A bullish divergence is given when prices make lower lows and RSI indicator make higher lows. A bullish divergence failure can be extremely negative and vice versa.

[bold]Ashish Kyal[/bold], is a Bachelor of Engineering (B.E.) and MBA. He is pursuing the Chartered Market Technician program and is an associate member of the MTA (Market Technicians Association, USA). Ashish has also worked in the Risk Management area for a leading commodity exchange in India. He supports his investment decisions using technical tools and is passionate about Investment psychology.

Mukul Pal
Orpheus Capitals, Global Alternative Research

This entry was posted in Primers and tagged , . Bookmark the permalink. Post a comment or leave a trackback: Trackback URL.

Post a Comment

Your email is never published nor shared. Required fields are marked *


You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>