Friday, March 12, 2010

RSI and Hayden’s hidden divergences

In my last post about John Hayden’s RSI: The Complete Guide (Traders Press, 2004) I noted that he takes a contrarian view of simple (or regular) divergence. “The appearance of a simple divergence [bullish/bearish] is a very strong indication that the trend is opposite of what the name implies." (p. 72) For Hayden an uptrend is in place when RSI values remain between 40 and 80 and there is a simple bearish divergence. The continuation of a downtrend is indicated when RSI values are between 60 and 20 and there is a simple bullish divergence. In brief, in most trends a regular divergence points to trend continuation, not trend reversal.

Hidden divergences, by contrast, do presage at least a short-term trend reversal. A hidden bullish divergence in a downtrend is a strong signal that the trend is about to reverse, even if only temporarily; a hidden bearish divergence in an uptrend points to a reversal down. Hayden’s hidden divergences are not, let me be quick to point out, what we commonly think of as hidden divergences. That is, they are not higher price lows and lower indicator lows in an uptrend or lower price highs and higher indicator highs in a downtrend that point to trend continuation. (See, for instance, Barbara Star’s "Hidden Divergence.") Hayden’s hidden divergences look like "their more common cousins” except they “do not occur at the bottom or top of the RSI chart. . . . They appear after the RSI has either rallied (bullish hidden divergence) or after the RSI has dropped from its high (bearish hidden divergence). Hidden divergence typically occurs in the 40 to 60 ranges. When hidden divergence occurs, it is classified as the strongest divergence possible. The market will do exactly as the name indicates.” (p. 70)

Hidden divergences are not major trend reversal signals; they are useful for traders who want to play countertrends. For instance, a rally presaged by a bullish hidden divergence in a downtrend that occurs at the 40 level is often stopped in its tracks when it reaches the RSI resistance level of 60. The downtrend may then reassert itself. A bearish hidden divergence in an uptrend is a similarly short-term play, with the pullback often ending when RSI reaches the support level of 40.

I have not tested the efficacy of Hayden’s hidden divergence signal. For savvy programmers it might be worth a few hours’ time.

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