Diverging from the Norm
Diverging from the Norm
If you have noticed a theme lately with my articles, you are correct. I started by writing about the Bounce or Break dilemma that most traders face and received such an overwhelming email response that I decided to detail more of how I identify probable price action at supply and demand levels.
So far, we have looked at price action and volume. Today, I will introduce technical indicators as an odds enhancer. It is important to remember that an odds enhancer is used to increase the probability of a trade working out, not to signal the entrance to a trade itself. You should still execute trades based on price analysis and supply and demand levels.
Whenever I start to discuss technical indicators, everyone always asks me what my favorite one is. I never get bored from watching the disappointment on their faces when I answer, "Price!" The truth is, all indicators are built on past price and relationships to that price with volume included on some. If you understand the mechanics of the indicator, then you know how it is likely to read and when it will give signals just from reading price on a chart. If you can do this, then you will be ahead of those who are relying on an indicator to render a buy or sell signal prior to acting.
However, indicators can be helpful when used properly. Since the buy or sell signals usually show late, we must observe the behavior of the indicator and take our signals from changes in that behavior. Enter divergence. Divergence is when the indicator is not exhibiting the same characteristics as the price of the security. When prices rise, you should be seeing higher highs and higher lows for the uptrend in price. You should also be seeing higher highs being made in the indicators. The opposite is true when in a downtrend, lower lows in price and the indicator.
There are two types of divergence, positive and negative. Positive divergence typically signals the pause or end of a downtrend. In positive divergence, the price of the security makes lower lows and lower highs, a downtrend. However, the indicator makes the same lows or possibly higher lows.
Figure 1
The divergence of the indicator shows that even though prices are continuing in the trend, they are doing so with less momentum and are unlikely to continue without a pause, correction or even a reversal. This is shown in the following chart with positive divergence in the MACD. Note that the divergence can occur in the MACD itself or the histogram to be effective.
Figure 2
Negative divergence typically signals the end, pause or correction of an uptrend. It occurs when prices are making higher highs and higher lows (an uptrend), but the indicator makes similar or lower highs. This lack of momentum being demonstrated by price and reflected in the indicator is a signal of weakness of the trend. Be watchful for reversal signals in this environment.
Figure 3
Figure 4
So now you have an added tool to judge your bounce or break of supply and demand. Use it wisely. Until next time, trade safe and trade well!
Have a great day.
- Brandon Wendell
"
About Brandon Wendell
Brandon has appeared as a guest on CNBC, Bloomberg TV, and Fox Business Channel. He has conducted special seminars for CNBC staff on technical analysis of the financial markets. Brandon has published articles in The Trader's Journal, Forex Journal, Investor Magazine, and Investor’s Business Daily. Brandon has also appeared as an industry expert speaker at the Trader’s Expo, The Money Show, and Asia Traders and Investors Conference.
View Brandon Wendell's post archive >
