Accurately Analyzing RSI Divergences

04/02/2015 6:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

Critics have tried to dispel divergence analysis, but these examples from MoneyShow's Tom Aspray show that when executed properly, reliable signals are generated that can help determine market tops and bottoms.

Almost 30 years ago, using a series of networked Apple II computers, I started doing research and began writing about divergence analysis. Over the years, I developed some rather specific guidelines to analyze divergences. In the past few years, there have been a number of articles about divergence analysis that I feel do not allow it to be judged correctly as a technical tool.

In my opinion, these all have one common flaw, as no matter whether they are trying to prove that divergence analysis works or doesn't work, they only look at the daily data. I have always focused my divergence analysis on the weekly data because I find it to be the most reliable.

Over the years, I have observed consistent weekly patterns in the Relative Strength Index (RSI) that are quite useful in determining both intermediate-term tops and bottoms. Often times, weekly RSI divergences will confirm signals from other technical tools like the on-balance volume (OBV), which gives even greater validation to the analysis.

In these examples, I am using the 14-period RSI with a 21-period weighted moving average (WMA). Typically, at major turning points, you will be able to observe the formation of one or more divergences at overbought or oversold levels that form over a six- to 20-week time period. These divergences then must be confirmed by a move in the RSI below a significant support level or above a key resistance level.

Generally, when daily divergences are formed but no there are no weekly divergences, the daily divergences just signal corrections within the intermediate-term trend. The daily RSI analysis can often be used to identify continuation patterns within the major trend.

Those analysts who are only looking at daily divergences conclude that divergence analysis does not work because they observe a series of daily divergences within an intermediate-term trend. As a result, they are often whipsawed and fail to catch the major trend.  

I hope the following examples will encourage readers to do their own analysis, especially on the weekly data, as only then will you have the confidence to act on your divergence analysis.

Figure 1

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Let's look at the weekly chart for Apple Inc. (AAPL), one of the most followed companies of the past decade. This chart covers the period from March 2007 through early-September 2008.

In April 2007, the RSI moved above its 21-period WMA (green line) as AAPL started its rally from the $90 area. Both the price and RSI continued to move higher until July, when the iPhone was released. The stock peaked just below $150, forming a weekly doji with the RSI at 83. During the following three-week correction, AAPL declined 25% from its highs and the RSI dropped back to support in the 55 area.

By the middle of September, the RSI moved back above its weighted moving average and AAPL closed higher for the next eight weeks. By early November, it had reached the $190 level.

The RSI did not make new highs, as it instead formed lower highs, line A, peaking just above 81. After a two-week correction, AAPL again turned higher, and by late December, the stock surpassed the $200 level.

At these new price highs, a second negative divergence was formed in the RSI, line B, as it only reached the 72 level. This suggested that an important top might be forming.

Two weeks after the highs (line 1), the RSI dropped below key support at line C. This confirmed the negative divergences in the RSI, consistent with the completion of an intermediate-term top. Over the next six weeks, AAPL dropped almost 30% before stabilizing in the $115 area.

By the end of March, the RSI had moved back above its weighted moving average. Over the following seven weeks, AAPL rallied slightly above $190. The weekly RSI rallied up to the 65-70 area, but by the latter part of June, it had dropped back below its WMA.  

The rebound in the RSI failed at previous support indicted by line C. After a six-week decline, the RSI bounced, but was only able to make it slightly above its WMA. The subsequent violation of the seven-month RSI support, line D, was a strong signal that the downtrend had resumed.

NEXT: Study Important Signals on Daily Chart for Apple

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Figure 2

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The daily chart for AAPL above begins in March 2007 and goes through April 2008. On April 28 (blue box), the weekly RSI moved above its weighted moving average and the weekly triangle formation was completed with the close above $99. The daily RSI was already above its weighted moving average, therefore, the weekly and daily trends were both positive.

The daily RSI peaked a month later, and then as AAPL continued to move higher, the RSI formed a series of three lower highs. These lower highs occurred very close together, which made them less significant, and with no divergences in the weekly analysis, these divergences were consistent with just a pullback, or period of consolidation.

After peaking on June 7 just above $125, AAPL traced out a triangle formation over the next four weeks. The daily RSI confirmed the completion of the continuation pattern when the RSI again moved above its weighted moving average. The rally continued into July, but the daily RSI formed a longer-term divergence at these highs, as indicated by line a.

The weekly RSI had not yet formed any bearish divergences (see Figure 1), so once again, the daily divergence was indicating a correction, and not an intermediate-term top. Still, the length of the daily divergence suggested this correction might be more significant that the prior one.

The decline retraced just over 50% of the rally from the December 2006 lows at $76.77 while the overall market was under heavy selling pressure. During this decline, the weekly RSI dropped back below its weighted moving average, which increased the odds that a weekly divergence would form if AAPL made further new highs.

The daily chart shows that a doji candle formed at the August 17 lows (see arrow), and just a few days after those lows, the daily RSI was back above its weighted moving average. It took until the end of September for the weekly RSI to move above its weighted moving average.

Still, the next rally was dramatic, and AAPL made a high of $192.68 on November 7 (line 1) before closing lower for the day. Four days later, it made a low of $150.73.

As you will recall, these November highs were not confirmed by the weekly RSI. On the daily chart, this period is highlighted by the red box. The daily RSI also did not move above the May highs.

As AAPL began to rally once more, the daily RSI moved back above its weighted moving average, but was obviously much weaker. This added to the evidence that an intermediate-term top was forming. The price action was impressive, and AAPL hit a high of $202.96 on December 27, but the daily RSI formed a further negative divergence, line b.

As discussed earlier, the weekly RSI formed a second bearish divergence and just barely moved above its weighted moving average. Therefore, the break of weekly RSI support, line C, in early 2008 (line 1), and the drop below the RSI's daily uptrend, line c, turned both the weekly and daily trends negative. This set the stage for a 30% decline into the latter part of February.

NEXT: Review Key Guidelines for Using the RSI

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Figure 3

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The weekly chart of Transocean (RIG) covers the period from November 2005 through September 2008. In early April 2007, RIG completed a weekly flag formation, lines a and b, that was confirmed by a move in the RSI above its year-long resistance, line c. 

This several-month rally took RIG from $87.40 up to the $117 level in late-July 2007. The RSI peaked above 81, point 1. After a quick, three-week correction, RIG resumed its uptrend, reaching the $150 level in late-December 2007, point 2.

The weekly RSI did not confirm these highs (point 2) and just two weeks later, the uptrend in the RSI, line d, was broken. The RSI then dropped back to the 50 level before it was able to stabilize and turn higher.

Even though the RIG made significant new highs above $160 in May 2008, the RSI formed another bearish divergence at point 3. These two divergences were then confirmed by the break of the 18-month RSI support, line e, the week ending July 18, 2008 (line g).

The weekly RSI then continued to drop sharply along with prices, staying well below its declining weighted moving average. By October 2008, RIG had lost half of its value.

Figure 4

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This weekly chart of the iShares Dow Jones Transportation Average Index Fund (IYT) provides a good example of both a typical weekly RSI bottom and top. For most of 2008, the weekly RSI was in a well-established downtrend, line a. The RSI made a low at 25 in late-October 2008, point 1, before rallying back to the 42 area.

The selling pressure picked up in early 2009 when IYT hit a low of $38.28 in March (point 2), which was well below the October 2008 low. The bullish divergence was then confirmed in April when the downtrend, line a, was overcome, and the RSI moved above its previous peak. The RSI was acting stronger than prices.

The RSI surged to significant new highs at 73 in May 2010 before dropping back to the 42 level in July 2010. This allowed the drawing of a new support level, line c, after the RSI moved back above its weighted moving average.

In late January 2011, IYT hit a high of $94.89 before reversing to close the week lower, point 3. The RSI failed to make a new high with prices, forming a nine-month negative divergence, line d.

By the latter part of March IYT began a new uptrend and made a further new highs at $100.67, the week ending May 7th (point 4).The RSI was significantly lower than it was January as it only reached 67 as opposed to 72 in January. This second negative divergence further weakened the intermediate term trend and identified line c, as the key support level to watch.

The week ending June 7th (line e) the RSI support at line c was broken, confirming the negative divergence and indicating that an intermediate-term top was in place. A further negative divergence was formed in July (point 5), and while IYT made a new high at $101.60, the RSI just barely moved above its declining weighted moving average.

Trading Conclusions

Here are some guidelines that might help you to use the RSI in your analysis:

First, look for weekly negative divergences that form over a six- to 12-month period or longer to identify significant market tops. These need to be confirmed by a break of support that goes back at least six months.

Short-term negative divergences, especially those that are not formed at overbought levels, simply signal corrections. Look for the formation of typical continuation patterns.

For market bottoms, you are more likely to see a single bullish divergence that forms over a four- to six-month period. Sometimes the daily RSI can help you fine tune entry points because when it moves through the 21-day WMA, it confirms a change in momentum.

In summary, be wary of daily positive divergences that develop in a downtrend or negative divergences in an uptrend if they are contrary to the weekly analysis. Selling just because the daily RSI is above 70 and has formed a negative divergence is only for the very nimble trader.

Look for the daily RSI to trace out triangle formations, as they will often be completed a day or two before the corresponding price formations.

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