In this short lesson we will review the bullish divergence trading strategy and demonstrate how it can be used to predict intraday reversals and price movements. This strategy uses a combination of indicators including multiple time frames, candle sticks, moving averages, trend lines, and relative strength.
This strategy can be used on nearly any time frame you choose, but this example will use intraday charts which are more advanced due to short term volatility that changes by the hour. This is high risk trading that should only be performed by experienced traders, otherwise stick to longer term charts such as the 6 Hour or Daily time frame.
Step 1: Finding Divergence
Bullish divergence in its classical form is described as:
- RSI enters the zone below 30
- RSI exits the zone below 30
- RSI re-enters the zone below 30 and fails to make a lower low
- RSI exists the zone below 30 with a higher low
- Price makes lower lows during Stages A-D
The bullish divergence in this example is easy to see on both time frames. Notice how price makes lower lows while the relative strength rises or runs sideways. This indicates that buyers are stepping in to absorb the sellers.
Step 2: Finding additional confirmation
Wait for relative strength to enter a bullish zone. In this case we use the indicator signal line in conjunction with the 60 Line. When RSI is trading above these levels on both time frames, there is a bullish bias.
Two time frames are used to confirm signals as its important to understand the high time frame chart is the dominant trend that will always prevail. It’s generally recommended that you use a factor of 4 between your Low Time Frame (LTF) and High Time Frame (HTF). In this day trading example we are using the 5 minute chart as the trigger (LTF) and the 20 minute as the context (HTF). 5×4 = 20.
Candlesticks can be used to gauge how the market is responding to price. The large downside wicks on the 20 minute chart are confirming the RSI divergence by indicating buyers are absorbing the sell orders.
Moving averages can be used to confirm RSI breakouts. When the RSI is above the signal line or in a bullish zone, price should be above the 21 or 55 EMA. In this example we see price broke out above the 55EMA on the trigger time frame while breaking above the signal line on the RSI. That was the signal to enter.
Volume is another important indicator that can be used to judge a price movement. Generally speaking, volume should increase with price, think of the volume as pushing the price up or down. In the 20 min (HTF) chart we see volume trading above average after the breakout as buyers rush in.
Step 3: Take Some Profit
When day trading, positions are usually highly-leveraged and reversals can come at any second, which is why its important to always maintain tight stops and take profit along the way. The trailing-stop loss strategy is a good way to reduce losses while letting profits run. Its a good idea to leave some position on the table (25-50%) depending on your risk tolerance and profit goals. You can never predict what’s going to happen in the market.