RSI Stochastic Divergence Strategy - Advanced Forex Strategies

RSI Stochastic Divergence Strategy

RSI Stochastic Divergence Strategy: It is generally known that the trend is your friend. Buying pullbacks within an established trend forms the basis for almost any trading following strategy. While there are many different approaches to trend trading, in this trading strategy we make use of the oscillators to find hidden divergences and trade in the direction of the trend. Hidden divergences are usually less frequent than the classic divergences. They are more valid and signal a more powerful trend continuation pattern.

RSI Stochastic Divergence Strategy – Chart Set ups

  • EMA’s 20 and 50, Closing prices: The two Exponential moving averages serve as a visual guide to the trend. We look for short positions when the 20 EMA is below 50 EMA and conversely, long positions are taken when the 20 EMA is above the 50 EMA
  • Stochastic: (14,3,3 High/Low Exponential): The Stochastic Oscillator will be the main indicator pointing us to hidden bearish and bullish divergences
  • RSI (13 or 14, Closing prices with 50-line only): The RSI acts as a trigger indicator for us to go long or short. Long positions are taken when RSI crosses above 50 and short positions are taken when the RSI crosses below 50, following a hidden divergence and trend confirmation from the Stochastic and the EMA’s.

Once the indicators are added to the chart, the set up is as shown on the chart below.

RSI Stochastic Divergence Strategy
RSI Stochastic Divergence Strategy – Chart Setup

  • Bullish Hidden Divergence: Price makes a higher low, Stochastics makes a lower low
  • Bearish Hidden Divergence: Price makes a lower high, Stochastics makes a higher low

The illustration below gives a quick snapshot of the two types of hidden divergences. We wait for these appear just before the EMA crossover or only after the first EMA crossover.

Hidden DivergenceRSI Stochastic Divergence Strategy – Hidden Bullish and Bearish Divergence

Trend divergence trading – Trade Set ups

For long positions

  • EMA 20 is above EMA 50 or has made a bullish crossover
  • Stochastics has signaled a hidden bullish divergence
  • Buy when RSI 14 crosses above 50-line
  • Set stops to recent swing low
  • Book first target at the most recent high
  • Trail the second target by moving to break-even after the first target is reached

For short positions

  • EMA 20 is below EMA 50 or has made a bearish crossover
  • Stochastic has signaled a hidden bearish divergence
  • Sell when RSI 14 crosses below 50-line
  • Set stops at recent swing high
  • Book first target at the recent swing low
  • Trail the second target by moving to break-even after the first target is reached

Important Notes:

  • A hidden bullish/bearish divergence is to be used only on the first bullish/bearish EMA crossover
  • There is a good chance that the second position often gets stopped out, unless where trends are strong in which case, the profit potential can be greatly magnified
  • For additional confirmation, look for inside bars or engulfing bars from the candlestick patterns

RSI Stochastic Divergence Strategy – Trade Setup

Short Set up Example

RSI Stochastic Divergence Strategy - Short SetupRSI Stochastic Divergence Strategy – Short Setup

  1. 20 EMA crosses below 50 EMA
  2. Stochastics shows a hidden bearish divergence
  3. RSI crosses below 50-line
  4. Additional confirmation: Bearish engulfing near the end of the hidden bearish divergence
  5. Short set up reaches the first target, while the second position would have been stopped out

Long Set up Example

RSI Stochastic Divergence Strategy - Long SetupRSI Stochastic Divergence Strategy – Long Setup

  1. EMA 20 crosses above 50
  2. Stochastics prints a hidden bullish divergence
  3. RSI moves above 50-line
  4. Long position is taken with stops set to the previous swing low
  5. The first target set to the recent swing high is reached
  6. Stops for the second position is trailed to break even and the trade is eventually stopped out at the next swing low point shown on chart

RSI Stochastic Divergence Strategy – Powerful Reversal Strategy

One of the biggest advantages of trading the hidden bearish divergence with the trend divergence set up is that trades are often reversed. The stops are usually tighter compared to the targets and when a trend starts to unfold, big profits can be captured. The trend divergence strategy can be used on time frames from H1 and up to D1.

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