Confluences are points on the price chart wherein there are several indications giving a hint where price is moving and all the indications point towards the same direction. Trading based on confluences significantly increases the likelihood of a profitable trade. Each indication has its own probabilities based on statistics. Trading on confluences means you are trading only when these indications intersect which should naturally have a higher probability.
Confirmation is the final indication that price is moving in a certain direction. This is often based on signals such as candlestick patterns, breakouts, moving average crossovers, or other entry signals that use technical indications.
This trading strategy is a strategy that has both elements. It trades on a confluence of an overbought or oversold mean reversal, a divergence, and it also trades on a confirmation or a reversal. It does this using the RSI with an added moving average line.
RSI with Moving Average
The classic RSI is a momentum technical indicator which is displayed as an oscillator. It identifies momentum direction based on an underlying computation that compares the current price with the recent price movements.
The RSI plots a line which oscillates within the range of zero to 100. It also typically has markers at levels 30 and 70, which represents the oversold and overbought levels. An RSI line dropping below 30 indicates an oversold market, while an RSI line breaching above 70 indicates an overbought market, both of which are prime conditions for a mean reversal.
Many traders also use the RSI to determine trend direction by adding levels 45, 50 and 55. The RSI line typically stays above 50 in an uptrend, with 45 serving as the support level for the RSI. Inversely, the RSI line also usually stays under 50 in a downtrend, with 55 serving as the resistance level.
One feature that the MT5 platform allows users to do is to layer indicators on top of one another. For example, users can add moving average lines on an oscillator type of indicator and calculate the moving average line based on the oscillator.
The example below shows us an RSI indicator with a 20 period Simple Moving Average (SMA) line applied on the RSI line.
Since the RSI is an oscillator which mimics the movements of price action closely, the relationship of the RSI line and the 20 SMA line also tends to be very similar.
The RSI line also tends to stay above the 20 SMA line whenever the trend is bullish, and below the 20 SMA line whenever the trend is bearish. Crossovers between the RSI line and the 20 SMA line can also indicate a potential reversal. Crossovers that come from an overbought or oversold RSI level tend to be high probability mean reversal signals.
Divergences as an Added Reversal Indication
Divergences can be an excellent added indication for a reversal, which is why we will also add this layer of confluence on our setup.
Price action typically oscillates up and down the price chart in a cyclical pulse of rallies and drops. This cycle of rallies and drops create peaks and dips, which is what we call as swing highs and swing lows or pivot highs and pivot lows.
Oscillators are technical indicators which tend to shadow the movements of price action on its own indicator window. It also plots lines are bars that rally and drop with price action. This also creates peaks and dips on the oscillator which closely corresponds with the swing highs and swing lows on the price chart.
Often, these height and depth of these peaks and dips would be commensurate with the height and depth of the swing highs and swing lows. However, there are scenarios wherein the height and depth of the peaks and dips of the oscillator would differ from that of price action. These are what we call divergences, and these scenarios are indicative of a probable reversal.
The chart below shows the various divergence patterns which are indicative of a reversal.
Trading Strategy Concept
This trading strategy is a confluence between a divergence based reversal signal, a mean reversal signal, and a crossover signal using technical indicators.
The RSI line is first used to identify oversold and oversold market levels based on the line breaching outside the 30 to 70 range. It is also used to identify divergences when compared to price action. Lastly, it is also used in tandem with the 20 SMA line to confirm the trend reversal signal based on the crossover between the RSI line and the 20 SMA line.
Buy Trade Setup
Entry
- A bullish divergence should develop between price action and the RSI with Moving Average indicator.
- The second dip of the divergence should be below 30 indicating an oversold market.
- Enter a buy order as soon as the RSI line crosses above the moving average line indicating a bullish trend reversal.
Stop Loss
- Set the stop loss on the support below the entry candle.
Exit
- Close the trade as soon as the RSI line crosses below the moving average line.
Sell Trade Setup
Entry
- A bearish divergence should develop between price action and the RSI with the Moving Average indicator.
- The second peak of the divergence should be above 70 indicating an overbought market.
- Enter a sell order as soon as the RSI line crosses below the moving average line indicating a bearish trend reversal.
Stop Loss
- Set the stop loss on the resistance above the entry candle.
Exit
- Close the trade as soon as the RSI line crosses above the moving average line.
Conclusion
The RSI is an excellent indicator to use for spotting possible mean reversals coming from an overbought or oversold level. However, not all RSI reversals from these levels would result in an actual mean reversal on price action.
This strategy adds another layer of confluence by trading only when there is a divergence which corresponds with the overbought or oversold mean reversal. It also uses the crossover of the RSI line and moving average line as the confirmation of the actual trend reversal.
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