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November 11, 2009

How To Use RSI

The week-long interval since my last post has been brought to you courtesy of visitors to the Docpad, including two runts from California, aged 12 and 8, who quickly annexed all the local computers for chatting and gaming. The blame is not all theirs, of course. Your host turns into a kid himself when the half pints are around. Anyway, to re-acclamate myself to the blogosphere, I have a short, warm-up post for you containing an insider tip from my personal TA manual.

Let's begin with a question: how many charts have you seen tossed online in which the author predicted an imminent trend change due to a divergence in RSI? How many times did the "imminent" trend change actually occur? (I lied. You got two questions.) The true divergence here is the difference between the number of predictions and the number of actual trend changes! Folks using RSI to predict trend changes are overlooking the vital fact that while trend changes rarely occur without an RSI divergence, a divergence itself rarely brings about a trend change. In other words, a chart can sport a series of divergences before price actually changes direction.

The key to using RSI lies in the first half of our vital fact: trend changes rarely occur without an RSI divergence. In other words, traders should not hunt divergences when studying RSI but rather lack of them. Check out the currect U.S. Dollar chart:

daily dollar chart

Given the lack of an RSI divergence, there is a low liklihood that the next bounce will mark a turning point in the dollar's trend. We should therefore weigh heavier odds on lower prices for the DX. Remember that everything in trading boils down to probability, and the point here is that a lack of a divergence sports a much higher probability of seeing a lower low after the next bounce than that of seeing a trend change after any given divergence.

 

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