The Relative Strength Index part II: Divergence
The Relative Strength Index part II: Divergence
Last week we went over the basics of the Relative Strength Index indicator. It’s important that you have read and understood the contents of that article before reading this article because I will not be explaining anything that was covered in that article. To read that article, please click here.
The RSI is an oscillator with a fixed lower and upper limit. It travels in a range between zero and one-hundred. This means that the RSI has a fixed range, it will never go below 0 and it will never go above 100. Just because the RSI hits an extreme high or low, doesn’t mean that the trend of the stock is going to change, this is a very important aspect of oscillators to always remember. Oscillators by their nature, will often indicate over-bought and over-sold conditions long before a trend is ready to turn. Let’s look at an example of this.
The daily chart below of Foster Wheeler Inc. (FWLT) shows the RSI indicator at 90.54, a pretty high reading, the highest in this set. Yet, the stock just keeps going higher (the reading for the RSI can be found in the Data Window, I drew an arrow on the chart pointing to the RSI reading).
On the day that the RSI reached its peak, the stock closed at $47.95. A few days later, the stock was trading at a higher price. In fact, the stock would work its way up to the $65 level before experiencing a correction of any size. If you sold just because the RSI was at an extremely high level, you would have missed out on over $15 worth of profit.
So what good is the RSI? For one thing, the RSI can give you a lot of information about the underlying strength of a trend. A trend can continue even though the force behind the trend is weakening, but it would be most helpful to be able to spot signs of weakness, so we could at least prepare for a possible reversal.
If you go back and look at that chart of FWLT above, you might spot one sign of weakness that appeared before the big July pullback. Can you see it? If you said ‘Divergence’ then give yourself a pat on the back! Let’s look at that same chart again, but in a different light.
From May to July, FWLT keeps moving higher in price. But these new highs are not being confirmed by the RSI. See how the RSI starts to make a series of lower highs and lower lows. It’s essentially in a downward channel even though the stock is in an upward channel. This is an indication that some big money players are starting to distribute shares and the trend is running out of steam. Please note however, that this divergence lasted for quite some time. You don’t sell or more importantly, sell short just because divergence is present. You need another indicator or signal to confirm that the momentum really is turning. A simple breaking of a trend line, or the stock going to 3 Red Arrow could be your sell signal.
You might have noticed another area of divergence began to form on the right side of the chart. If so, pat yourself on the back again! Let’s go a little forward in time and focus on this area because divergence is one of the most powerful uses of the RSI indicator.
You can see the earlier area of divergence on the left side of the chart, but now you can see the next area of divergence on the right side of the chart. The stock is making a series of higher highs, but the RSI isn’t only failing to make highs to confirm the price action, it’s also failing to get back above 75. This is not a good sign, and you can see the sell off that occurred.
I’ve talked about divergence before (to read an article on divergence with the MACD, click here). I even mentioned last week that I don’t trade with the RSI indicator, but I do use it to confirm divergence that I might spot in the MACD indicator or Stochastic (usually it’s the MACD, as the Stochastic doesn’t always show divergence as well as the MACD does). Let’s take a look at an example of this.
I’ve been worried about steel stocks for a while now. I started to spot quite a bit of divergence on several of the leaders in this space. The first chart shows a daily chart of Mechel Steel Group (MTL), note the very strong divergence as the stock makes a series of 3 higher tops (there’s that number again, 3, hmmm, is that important? Believe it or not, a lot has been written about the number 3 and trading), meanwhile, the MACD and the RSI make a series of lower highs.
This stock finally began to weaken in price, long after our indicators warned of of the underlying weakness that was creeping into the trend.
The next chart of U.S. Steel (X) shows the divergence as well.
The divergence, although not stretched over as long a time period as the one on MTL, is still well pronounced on X. And boy did this stock get spanked last week! When you start to see divergence in several charts of companies in the same industry, pay attention. This is a serious warning sign. This divergence doesn’t mean the stock is going to start a downward trend. It might, but it could also signal the beginning of a long consolidation period. We saw earlier on FWLT, how the divergence led to short term down trends, but the long term uptrend in the stock remained intact.
I’m starting to see some divergence in many of the ag/fertilizer stocks that have been so hot for so long. Below is a chart of Potash of Saskatchewan (POT). Can you spot the divergence?
And here is a chart of CF Industries (CF).
As of this writing (July 3, 2008), these stocks have pulled back to trend lines that are providing support. If the support holds, then the divergence might not be anything to worry about, although it might signal a beginning of a long consolidation period for the stocks. However, if those support levels don’t hold, then the divergence present between price and indicators were definitely warning signs.
Divergence at bottoms
Divergence can also be a very bullish sign. When a stock makes a lower low, but the RSI doesn’t make a lower low, instead it makes a higher low, it can be an indication that the bears are losing control and beginning to weaken. It can be very exhausting after all, chasing bulls away. This type of divergence is often called “Bullish Divergence”, for obvious reasons. The chart below is a very good example of this.
Above is a daily chart of Oceaneering International (OII). You can see a picture perfect double bottom formation in February and March. Double bottoms are better when they are confirmed by divergence in indicators such as the MACD and the RSI as is the case in the chart above.
The next chart of Apple Inc. (AAPL) is a bonus one because we see a bearish divergence form, then a big drop, then a bullish divergence began to appear before the stock made one heck of a recovery.
The bearish divergence was a warning sign that the stock was getting a little too toppy. After the rather large and lightning quick drop, AAPL began to form a very bullish area of divergence. The bulls were definitely trying to make a comeback, and they did.
Conclusion
Divergence is something you’ve seen write about before and you’ll see me write about again. Divergence between price and indicators is one of the most powerful uses of the indicators. The divergence often comes before a break of a trend or the stock going 3 red arrow. It alerts you to a possible change in trend. Don’t neglect the weekly charts, either. If you see divergence on weekly charts, pay attention, it could be serious. Bearish divergence on the weekly charts was everywhere coming into June of this year, and you all know what a bad month it turned out to be for the bulls.
Don’t forget to always look for divergence when you are doing your analysis. Remember though, divergence isn’t always fool proof. You will often see divergence appear, but as a stock continues to push higher (or lower if in a down trend), the indicators will eventually make a new high as well. But when you have another bearish sign, such as high volume selling or a break of trend line or support line, then your price is starting to come into alignment with the indicators and you have to ask yourself if it’s worth it to stay in the trade any longer.
Happy trading!
-Mark Jackman
Stock Investor Personal Coach