The Relative Strength Index (RSI) is one of my favorite technical tools. I throw this indicator on the bottom of almost every chart I start to analyze.
The RSI is part of a group of technical tools called momentum oscillators. What is their basic function? They simply attempt to measure the speed of the change in price. Trend following traders are always on the lookout for good momentum, or strongly trending markets. And, of course, once that momentum begins to dry up that is also something traders need to know.
An extremely valuable aspect of RSI is the ability to monitor waning momentum. Readings called bearish and bullish divergences will warn of impending tops and bottoms. Technicians like to see the RSI continue to make new highs (or lows), along with price in trending markets. When that fails to occur, a divergence is formed. Let's take a look at an example.
A classic bearish divergence is seen on the daily Euro/Yen (EUR/JPY) chart. See Figure 1. In late October, at point A the pair made a new recent rally price high. But, that price high was not confirmed but a higher reading on the RSI. See Point B on Figure 1. The RSI etched a lower high or a bearish divergence warning that the market was vulnerable to pullback, which is what evolved in the weeks ahead.
Looking at action in euro/yen now, it remains trapped in a bearish sloping channel. Read the commentary here for key levels to watch on euro/yen near term.
Bullish and bearish divergences in momentum tools, such as RSI, can be very helpful in warning traders that a current trend may be running out of steam. Even if the market is simply embarking on a corrective pullback to the major trend, it could be a useful signal to book partial or full profits on a trade, depending on one's time horizon.
Bottom line? Divergences, when they appear, can be very powerful and significant technical signals.
Kira Brecht is managing editor at http://www.TraderPlanet.com
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