Trading strategy: Divergence Candlestick

Description

Divergence strategies are based on the divergence between the direction of the market price and the direction of an indicator. These strategies assume that when the market price and the indicator increasingly diverge, the market price will change direction. The Divergence Candlestick strategy uses candlestick patterns to generate trading signals. The signals are filtered by a unique slope filter which compares the slope of the market price and the slope of the RSI indicator. The strategy is based on a suggestion made by German trader-coach Thorsten Helbig.

The strategy in detail

The WHS Divergence Candlestick strategy is usually applied on a 60-minute chart. There are two steps:

Step 1: detecting signals
Potential entry signals are given by candlestick patterns. The NanoTrader Full platform is already capable of detecting many candlestick patterns. This tool is part of the indicator list and looks like this:

A potential signal is generated when a Bearish Engulfing pattern is detected. A description of the Bearish Engulfing pattern as well as 7 other patterns can be found here.

Step 2: validating signals
All new signals are subjected to a filter which will either accept or block the signal. This unique filter compares the slope of the market price curve to the slope of the RSI curve. The comparison is done by using special charts developed for the purpose. These charts based on moving averages are smoother than the classic charts. Smoothing charts reduces, for example, the number of tops.

The term slope refers to the slope of a special trendline applied to the smoothed market price chart and the smoothed RSI chart respectively. The special trendline is a straight line which connects the last top and the highest top of the previous 5 tops. For example:

Both the classic charts and the smoothed charts are visible in the trading platform. The smoothed charts are the thick, light blue curves. The filter accepts a bearish engulfing short sell signal when the trendlines of the smoothed charts diverge i.e. when the trendline of the price chart has an upward (positive) slope and the trendline of the RSI chart has a downward (negative) slope.

In this example the slope of the price chart is positive whilst the slope of the RSI is negative.

Under these circumstances the filter will accept short sell signals based on the bearish engulfing candlestick pattern. This is indicated by the red background in the chart.

When to open a position?

A short sell position is opened at the open price of the next candle when two conditions are met:

- The candlestick indicator has detected a Bearish Engulfing pattern.
- The special slope filter accepts the signal.

In this example a bearish engulfing pattern was detected (red triangle). The background of the chart is red indicating that the slope filter will accept short sell signals.

When to close a position?

The WHS Divergence Candlestick strategy uses 2 stops. It combines a Breakeven stop and a Time stop. The strategy also uses a profit target.

- The Breakeven stop is 3x the Average True Range (ATR) of the last 20 periods.
- The Time stop will automatically close the position after 14 periods.
- The profit target is 2x the ATR of the last 20 periods.

In this example the profit target (green line) was nearly reached. The market, however, changed direction before. The position was subsequently closed by the Breakeven stop (red line).

In this example the profit target (green line) is reached.

Variations of the strategy

In essence the active investor can combine 8 candlestick patterns with 4 slope scenarios. However, not all combinations are logical. The 4 bearish candlestick patterns (bearish engulfing, evening star, three crows, outside down) should only be combined with divergence case 2. The 4 bullish candlestick patterns (bullish engulfing, morning star, three soldiers, outside up) should only be combined with divergence case 3.

In the SmootherFilter indicator the user can change the parameters of the slope filter. Case 2 and case 3 are the divergence situations. Case 2 must be combined with the bearish candlestick patterns. Case 3 must be combined with the bullish candlestick patterns.

If the user opts for a bearish candlestick pattern the TradeDirection parameter should be 0 (short sell). If the user opts for a bullish candlestick pattern the TradeDirection parameter should be 1 (long). It is possible the combine candlestick pattern of the same category (bullish or bearish).

Conclusion

The Divergence Candlestick strategy combines candlestick patterns with a unique slope filter. This filter analyzes the divergence between the market price and the RSI indicator. The special smoothed charts and trendlines contribute to the unusual character of this trading strategy. The strategy template is set to use the bearish engulfing candle stick pattern. 7 additional candlestick patterns are available. The Divergence Candlestick strategy is suitable for market indices, forex, commodities and shares. Users can experiment with shorter time frames.

Practical implementation

In NanoTrader Full follow these steps:

• Choose the instrument you wish to trade.
• Open a chart with the template study "WHS Divergence Candlestick".
• Semi-automated trading? Simply activate the TradeGuard+AutoOrder or the AutoOrder function.