Let us have a look at the figure below that shows a price chart together with a 14-day RSI indicator under. The indicator usually follows the price, i.e. a high in RSI corresponds to a high in price etc.

*(from NinjaTrader)*

Nevertheless, in the figure we can observe a “divergence”, that is, even though the price makes a lower low (see the right blue circle), the indicator seems to increase (see the right red circle in the indicator). This may reveal that the downtrend is over so that a trader may consider bullish position.

But is it really true? This is something I decided to check by creating a computer program that detects two lows close to each other. As soon as it happens, the software gives a “buy” signal, as shown in the figure above. The take profit level is assumed to be at the maximum between the lows (denoted as TP in the figure) and a stop-loss is assumed to be 50 cents below the right minimum. Of course, this is a very simple strategy, which we will not use in practice as it is. The objective is only to check whether a bullish divergence in an indicator (i.e. 14-day RSI) will help to “lift” the market.

At first, we will test stocks that are currently in the S&P 500 index, without considering any bullish divergence. Here are some selected results (using NinjaTrader software using data from Kinetick):

Profit factor | 1.12 |

Max. drawdown | -35.70% |

Number of trades | 10092 |

Percent profitable | 38.58% |

Average trade | 0.64% |

Ratio win/loss | 1.81 |

Number of days held | 32 |

The results for the Russell 3000 index are as follows:

Profit factor | 1.10 |

Max. drawdown | -32.97% |

Number of trades | 26070 |

Percent profitable | 38.09% |

Average trade | 0.64% |

Ratio win/loss | 1.81 |

Number of days held | 32 |

And now let us consider the case when the bullish divergence occurred. For the stocks from S&P 500 index:

Profit factor | 1.20 |

Max. drawdown | -12.36% |

Number of trades | 1512 |

Percent profitable | 43.45% |

Average trade | 0.91% |

Ratio win/loss | 1.59 |

Number of days held | 25 |

and for stocks from the Russell 3000 index:

Profit factor | 1.19 |

Max. drawdown | -11.07% |

Number of trades | 3834 |

Percent profitable | 43.90% |

Average trade | 0.78% |

Ratio win/loss | 1.53 |

Number of days held | 23 |

So the results actually improve for the case when the bullish divergence was detected, see the better maximum drawdown, a higher average trade, and a higher percent of profitable trades. The ratio/win loss ratio is perhaps lower but this can be due to the lower number of days in trade.