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Divergence (Again)

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Divergence (Again)
Buzz Lynn

Please pass the crow. Some days we get it right. Some days we don't. Thanks God Options 101 is an education column and not "Mr. Market's Crystal Ball Minute", whose most obvious viewers would be soothsayers, witchdoctors, and a bucket of Wall Street analysts. Like Scott McNealy said a few years ago, "If they didn't see the cliff coming, how do they know we've hit bottom?" Good question.

From last weeks column, you may recall that we spent a great deal of time going over what bearish divergence looks like on a chart and how it might be useful in determining future market direction. We determined that based on the divergence of price vs. oscillators in an overbought condition, the markets looked poised to roll over and die again. What a difference a week makes! The only saving grace was using the words, "possibility" and "probability" of a market reversal. The truth is that we never know for sure. And the last two days of action, especially today, proved that point.

Not only did price action not decay, it took off to new recent highs today. And therein lies the practical lesson that no single indicator should be used to determine market direction let alone a single trade.

As a side note before we get back to divergence - bullish divergence - today's market rally looked rather convincing in helping me change my temporary market bias (read that trading bias) to bullish for two reasons. First, volume was the highest we've seen on the NYSE since July 26th, a sell-off day back then. The same is true for NASDAQ stocks. High volume has typically happened on down days lately. But today marks a change in favor of the bulls.

Second, many "pointy finger" charts, actually called "point and figure" charts, broke through their bearish resistance lines. While that can happen on any given day, it happened on large box sizes with the SPX and NDX. Institutions must have been slobbering all over themselves. And judging by the volume, they let their presence be known. Accumulation in strong hands appears to be taking place.

That said, I am no market wizard. I've been wrong before and I'll be wrong again - maybe as early as tomorrow. It's when I've been the cockiest in any facet in life that I've also been one day away from getting knocked down a few notches. One thing a playground fight teaches the young, let alone what the market teaches adults who care to learn, is humility. Just when we think we've got it nailed, it nails us first.

OK, back to bullish divergence. We promised that we would talk about it when we finally saw a chart that accurately reflected its presence. Well, as noted above, what a difference a week makes. Just when we had given up the retail sector or the NASDAQ for dead, we now see the slightest hint of bullishness. Admittedly, this is a weak example, but it's there, if only to the slightest degree.

Again, do not use divergence as an isolated trigger for play entries. It is only a technical pattern that makes market direction change a little more probable. It is not a guaranty; just another arrow for the quiver. Shall we take a peek at a previous Limburger cheese of a security? Note the NASDAQ-100 as shown by the QQQ (AMEX:QQQ).

NASDAQ-100 chart - QQQ (AMEX:QQQ):

Remember that divergence happens when the slope of 2 lines - price and oscillator - diverge. Bearish divergence happens when oscillators are overbought (see 11-14-2002 Options 101). Bullish divergence happens when the oscillator is oversold. In bullish divergence, a lower price low is accompanied by a higher stochastic value, as in the chart above. But as we noted last week, the opposite can be true too. We could have a higher price low accompanied by a lower low stochastic value. Either way, it's bullish as long as the price and oscillator slopes oppose each other as the oscillator emerges from oversold.

Granted, I took a little liberty with the chart above. Normally, I'd use two oscillators - a five and a ten period stochastic lookback. However, I only used a ten period lookback for the above example. Why? The five period lookback didn't show any divergence, which makes this a weak example of a potential bullish move. Similarly, I could have used the five period lookback on another chart to suit my purpose instead of the ten period. It too would be equally weak without confirmation by the other. But it does demonstrate what bullish divergence looks like on a chart, which is all we're after tonight.

Note that since the divergence took place, there has been a nice bullish move in the QQQ. However, it is entering overbought again. Now is not the time to abandon good money management and squander thy whole wad on the QQQ. There is NEVER a time to abandon good money management for any play. Don't start now!

OK, here's another example of bullish divergence, but requires an even further stretch of imagination. Again, focus on the pattern, not the actual sector.

Retail Index - RLX (INDEX:RLX.X):

See that? Once again, two opposing lines from an oversold oscillator signifying possible directional change. Is retail actually looking bullish? Only with an active imagination! Translation: Don't go open positions on the retail sector just because you saw the chart here tonight. Note that the only reason we see divergence here is because price action dipped to intraweek lows caused by a few mid-week hours or minutes of bearish market action. Using the wicks, we can make the argument for bullish divergence. However, using the candle bodies only, divergence does not exist.

So why show it as an example? One - to demonstrate the chart pattern. Two - there is a never-ending debate among technicians (published authors on the subject included) as to what really constitutes a good data point. Some argue that wicks count. Some say only to acknowledge the candle body at the end of the time period. My personal preference is to use whatever fits with the other 100 sets of facts/indicators surrounding the trade. Talk about non-committal! Sometimes I include wicks, sometimes not, depending on many other market factors. It comes down to a matter of personal preference. In other words, art, not science.

Well, if this business were any easier, everyone would do it. If it were any harder, no one would do it. Anyway, now we have another tool to help us determine the ultimate direction of which way we'll trade. We won't always be correct in our trading decisions, but divergence, especially strong divergence signals, can tilt the odds slightly in our favor.

Until next time, make a great weekend for yourselves! Oh, and since next Thursday is Thanksgiving, be sure to give a few moments of thanks for all the abundance and blessings we still enjoy. It's a far cry from the harsh conditions encountered by those landing on Plymouth Rock over 350 years ago. And for that alone, I am thankful.

Buzz



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