After a month of full on trending, some of the Aussie pairs are beginning to show signs of divergence.
GBP: AUD looks the most clear cut example to me. A weak close to the current candle would also mean an Evening Star Pattern. This is an added bonus that candle stick traders might use as a logical basis for early entry on a sell set up.
The daily chart below is showing divergence between price and the RSI.
Assuming yesterday’s high is left as a trend peak, then it will be higher than the previous peak. But while price is making higher highs, the RSI has started to make lower highs.
This divergence or loss of momentum often comes before a trend change.
One approach to RSI divergence set ups is to look for patterns that start from the overbought zone above 70%. Using the “1, 2, 3” method a sell position is opened when the RSI breaches support between the 2 highs (dashed red line)
Because the RSI is calculated on the candle’s closing value, many traders will wait for the close to confirm the set up before entering. A market sell order is then placed at the opening of the next candle
With daily charts, this has the added advantage of not needing to be glued to the screen. Just check things out in the morning and sell at market if the trade has set up.
As I write, the current candle has the potential to complete an Evening Star. This is one of the classic candlestick reversal patterns. The screen shot below shows how it works.
With an evening star, the body of the middle candle should not overlap the body of the first and should also be small (certainly a lot smaller than the body of the green candle leading into it). The example in the diagram has basically no body at all. This is a doji, making this example an Evening Doji Star.
With 24 hour markets like FX, the opening will usually be at the same price as the previous close so the 2nd candle needs to close at or above its open to prevent overlap into the body of the one before. The exception is Monday morning. With the GBP:AUD example – the 2nd candle is Monday’s so we did actually have an open above Friday’s close.
The Evening Star is a 3 candle formation. The 3rd candle must be red and must overlap well into the body of the first (e.g. 50%)
So it all tells a logical story of potential trend reversal
- Strong ongoing upward momentum represented by the first green candle that follows a well established uptrend
- A stronger opening on the 2nd candle but then indecision and loss of momentum represented by the small body and close near the open
- Finally weakness represented by the 3rd red candle that moves well into the body of the first
So a weak close today might give us an Evening Star. One approach to this would be to use this sign of weakness as an early entry trigger and sell even if the RSI does not close below its support. If nothing else it provides confirmation of the divergence set up.
In either case a typical approach to the stop loss would be to place it above yesterday’ high. Profit objectives might be based around the logic that a reversal here may see a correction of the last major swing higher.