Binary Trading Strategies Series 2: trade the RSI divergences
Trading overbought and oversold areas
The traditional way traders use the RSI is for its overbought and oversold levels: the simplest way is to enter a long position if the RSI goes above 30 and enter a short position when the RSI goes below 70.
The main issue while trading RSI is that the price could keep going up in overbought area and down in a oversold area.
While using the RSI in this simple way could lead to good trades, trading divergences between the RSI and the price movements could be even more profitable.
Divergence is identified by comparing indicator and market direction; when divergence occurs, it indicates a potential change of the price direction.
Divergence occurs when the price direction is different than the direction of the indicator, in other words they head in two different directions. Bullish divergence shows up when price makes lower lows and RSI makes higher lows; bearish divergence on the opposite occurs when price makes higher highs and the RSI makes lower highs. When divergence is spotted, traders can use this the strategy to enter into short positions in case of bearish divergence and into long positions in presence of bullish divergence.
The RSI divergences
Example of RSI divergences
Even trading the RSI divergences could have the same problem: the price could keep going up even in presence of a bearish divergence and down in presence of a bullish divergence.
Combining the RSI with an indicator or a trading system which could identify precise entry points and stop loss rules could significantly increase the probability of success in forex, stocks or derivatives trading.
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