subject: Which Is A Better Trade Signal, Divergence Or Reversal? [print this page] When you trade do you know what a divergence is? Do you know what a reversal is? Do you use the RSI to find these powerful signals?
Many Forex traders including experts do not understand the difference between a divergence and a reversal on RSI, the Relative Strength Index. Many if not most traders have never heard of Negative or Positive Reversals on RSI. Often they are referred to as Bullish or Bearish Reversals. They are the momentum maker signals for all of trading.
Even experienced traders who use RSI do not know that reversals exist. If they do they do not know which is better a divergence pattern or a reversal pattern. Most indicators that are used in trading are used to determine if prices are overbought and/or oversold. This is a myth that will lead to losing money or lead traders to misuse RSI or other momentum indicators.
Overbought and oversold are relative terms that have no meaning in regard to momentum. Often you will read that you should sell when RSI reaches 70 on the scale and buy when it reaches 30. This is completely the opposite of what happens and should be avoided.
Reversals and divergences are the key signals that should be considered on RSI and every trader should know what they are and when they form.
Here is a list of the four signals:
- Negative (Bearish) Divergence
- Positive (Bullish) Divergence
- Negative (Bearish) Reversal
- Positive (Bullish) Reversal
Statistical research has shown some very revealing things about these signals. Consider the following for a 6 month period on the EURUSD hourly currency pair in the first half of 2010.
- Negative (Bearish) Divergence (-204 pips on 32 trades)
- Positive (Bullish) Divergence (5,761 pips on 91 trades)
- Negative (Bearish) Reversal (14,734 pips on 164 trades)
- Positive (Bullish) Reversal (-5418 pips on 135 trade)
What does this tell us? The EURUSD moved in a consistent down trend during that 6 month period. The most successful of the 4 signals in a down trend are Negative (Bearish) Reversals with 14,734 pips made if one had traded all 164 signals. This is roughly 90 pips per trade. With about 120 days in a 6 month period that is more than one signal per day.
Second were Positive (Bullish) Divergences. These signals produced less than a third of the Reversal trades but were still productive with on average around 60 pips per trade. Notice that in down trending markets that Negative (Bearish) signals would be indicating when the trend is resuming whereas divergences would be indicating when there were retracements.
The other two signals, in down trending markets should be avoided and our expectation statistically would be the exact opposite in up trending markets. Learn these signals and learn how and when they occur so that you can profit from this incredible knowledge.
by: Paul Dean
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