At some point in your life (maybe even recently), you’ve likely heard the saying, “trust your gut – it’s always right.”
While that may be true for some things, like your health, it’s the last piece of advice you want to follow when it comes to trading.
In fact trading by your gut is really no different than trading by emotion, which is the fastest way to lose your money.
Instead, all you need to know is when and where a stock will move.
And this “crystal ball” will tell you each and every time…
How Conflict Can Be a Good Thing… and Lead to HUGE Profits
The developer of the relative strength index (RSI), James J. Wilder, was a strong believer that divergence between the RSI and a stock’s price is an undeniable indicator of a turning point or reversal for that stock.
While the RSI measures the trend, divergence tells you where that trend is going and predicts the moment when a stock will turn
It occurs when the price action of a stock (underlying asset) conflicts with the data that a technical indicator provides. In this case, we’re talking about a disagreement between the price action of a stock and the data that the RSI provides.
Now we know that the market can change at any time, but you can recognize and react the right way by knowing that there’s about to be a shift in the price action. This will lead to increased profitability in your trades.
There are two types of divergence that you will want to look for:
Bullish divergence: When the stock price, the underlying asset, makes a lower low and the RSI makes a higher low. This gives indication momentum is gaining steam because the RSI doesn’t confirm the lower low.
Bearish divergence: When the stock price, the underlying asset, makes a higher high and the RSI makes a lower high. This gives indication momentum is losing steam because the RSI doesn’t confirm the higher high.
No matter how long it took or takes, keep an eye out for the price and the RSI relationship. When you get a bullish move out of an oversold zone like in the visual example above, and it is backed up with a positive divergence, a chance for a higher move in price of the stock has a much greater chance of happening.
Now it’s important for me to point out that you may get multiple divergences in up and down trends. With that understanding, you should know this isn’t necessarily the best setup to use with the RSI. A better way to use the RSI is by looking for what is called failure swings.
Bank Higher Profits by Detecting a Trend Reversal
Wilder considered failure swings strong indications of an impending reversal as well. I reiterate, Failure Swings are based on the RSI itself NOT price action.
Failure swings occur when a technical indicator – the RSI – is in an overbought or oversold zone and signals that the current trend is weakening… and a reversal is highly probable.
They can provide higher reward opportunities because you will know what to do when the market is going the way you expected AND when it goes the complete opposite direction.
Like divergence, there are two types of failure swings:
Bullish Failure Swing: When the RSI comes out of the oversold zone by rising above the 30 line, retraces back to and holds at or above the 30 line and but then fails to reach the same level that it did before and turns downward again (forms an M pattern) then sees the RSI line break above its recent RSI high. Do not look for a divergence in price when this is forming as this signal is the focus, not price.
Bearish Failure Swing: When the RSI comes out of an overbought zone by crossing below the 80 line, retraces back up to and holds at or below the 80 line and but then fails to reach the same level that it did before and turns upward again (forms an M pattern) then sees the RSI line break below its recent RSI low. Do not look for divergence in price when this is forming as this signal is the focus, not price.
That failure to make the higher high or lower low is the failure swing, and indicates that an uptrend or a downtrend may be ending and reversing soon. Failure swings are solely focused on RSI and basically ignore the concept of positive or negative divergences.
That said, in the RSI screen for QUALCOMM Inc. (NASDAQ:QCOM) below, I have highlighted the following points to show you how the failure swing setup works – and what it looks like:
- The RSI is below the 30 line and coming out of the oversold zone by crossing above the 30 line.
- RSI comes back to and holds at the 30 line showing a bit of strength in the oscillator.
- The RSI line works its way above a recent RSI line high indicating a potential reversal to the upside.
The RSI has lasted for over 30 years. In that time, much has been written about it and there have been many variations to it.
The RSI can indicate the strength of the existing trend, and traders look for it to show if a stock is oversold or overbought. They next key on whether that momentum that propelled them into these areas or zones is reversing course – and capitalize on these price moves.
As I said earlier, there’s a right way and a wrong way to capitalize on market trends.
As a trader AND a teacher, I always say that when setting up your options trades, it’s best to know your expected price move in a stock and the time frame it can take to get there.
The RSI does not offer that, but you can look to initiate a bullish set up on a move out of the oversold zone and anticipate selling when it gets to an overbought reading to start.
The trick to using the RSI is recognizing failure swings and divergence and using that to enter high-income trades.
Subscribers to my Money Calendar can see the price expectancy and time frame of that price move. The RSI – as well as any number of similar momentum oscillators could be a complement to it.
Here’s Your Trading Lesson Summary:
|Earlier this week, I gave you the best momentum indicator to use to measure the trend of the market. Using the RSI can also help you predict where that trend is going and when it will shift direction. The two things to look for are:
- Bullish divergence and bearish divergence
- Bullish failure swings and bearish failure swings