Option Investor
Trader's Corner

Paying Attention to Technical Divergences

HAVING TROUBLE PRINTING?
Printer friendly version

I don't think there is much more in trading terms more worthwhile than to be forewarned of the next substantial trend reversal. I look at 'substantial' reversals as being of a 2-3 week duration or more and especially and where there is a substantial price swing up or down. This being a holiday break, I've had more time on my hands and I perused some of my colleague's work and writings. (I intended to post this last week, as I usually write my Trader's Corner articles on Wednesday, occasionally on Thursday, but here it is on the eve of the new year!)

I ran across an Option Investor Trader's Corner article from Linda Piazza's, who I alternate these articles with, from April (4/8/07) where Linda wrote about 'divergences', with this excellent pointer on their use: "Divergences warn traders to prepare their trading plans. They do not promise that a move will occur or that the plan will immediately be put into effect. Notice divergences, devise or revise your trading plan accordingly, but then wait for price action to confirm."

I'll add my two cents worth about how to use divergences to be ready to pounce on a trade, in both stocks and the index and with a somewhat greater emphasize on the use of HOURLY charts, coupled with use of a particular technical indicator.

THE CONCEPT OF 'CONFIRMATION' AND THE CONTRARY CONCEPT OF 'DIVERGENCE'

Charles Dow was the first to write extensively about how and why his two stock market averages ought to move in tandem. Specifically, if the Dow Industrial Average (INDU) went to a new closing weekly (or monthly) High OR Low, so should the related Dow Transportation Average (TRAN) at some point and vice-versa. Since TRAN represents the shipping companies and INDU the producing companies (more so in Dow's time), a pick up or a fall off in shipping, as reflected in the Average's stock prices, could be the first signal of a strengthening OR weakening economy.

For example, if INDU went to a new closing weekly high, 'unconfirmed' by a similar new high in TRAN, this non-confirmation or 'divergence' in the Transports could suggest that INDU will fall later; e.g., after inventory build up finally caused a weakening of the Industrial companies' profits, a surge in employee lay-offs, and generally created a slowing economy and perhaps a recession at some point.

Around mid-July, BOTH the INDU and TRAN averages went to new closing weekly highs per my first chart below. In October, the new closing weekly high in INDU was NOT matched by a new closing high in TRAN, by a wide margin in fact! This warned of a sell off in the market that was to come and those who heeded this warning tended to be better prepared or profited from the ensuing downturn. The market then got further along to a point where BOTH INDU and TRAN went to new low weekly Closes, suggesting that the major trend may have shifted from up to down. My focus will now move to the advance warnings we can get from a price/momentum INDICATOR divergence.

This foregoing is just about how price action of one market sector could be compared. Likewise, a rise or fall in the semi-conductor stocks could be the first tip off for a later move in Nasdaq. A surging oil stock sector could signal related strength in the S&P.

PRICE ACTION VERSUS TECHNICAL INDICATORS

A technical indicator is just a formula based on price or volume action so it's related for sure. If a stock or index goes to a new High or Low, an indicator type [Stochastics, MACD or the Relative Strength Index (RSI)] that measures price MOMENTUM should also go to a new relative high or low. The way I mostly look at divergences is by looking a trendline of new closing highs or lows in PRICE, versus what a trendline is showing as to the upward or downward trend in a related INDICATOR. My indicator of choice is the Relative Strength Index or RSI.

The RSI is basically a ratio of a moving average of the UP closes divided by a moving average of the DOWN closes for a certain period of time or a certain number of BARS in bar or candlestick chart. Lots of consecutive UP closes and the RSI line will go up steeply and vice-versa.

I'll use in my chart examples of price/RSI divergences the Close-only 'line' chart. While the RSI may be computed and re-computed for each price tick, the RSI line is not established until the Close of an hour, a day, week or month. The RSI indicator has to be told HOW MANY closing prices from what number of trading periods it's to use in order to compute an RSI line; e.g., 5 hours or days, 8 periods, 13, 21, etc. A daily moving average is always dropping off the Close of X number of days ago and using the latest Close to re-compute the average. You really have only one setting to make with the RSI, that of 'Length' or the number of trading periods to use in its calculations.

In my first chart example below, via the highlights I've used on the lower left of the daily line chart of Intel (INTC), the trend of prices was down, but the trend of the 13-day RSI was a pattern of higher highs; this divergence is easy to see as the price and RSI trendlines point in different directions as one is declining and one is (strongly) rising. A falling trendline drawn through the lows, accompanied by a rising trendline in RSI, is considered to be a bullish divergence between price and momentum (as measured by the RSI indicator) and points to a potential for an UPSIDE trend reversal ahead.

A bearish Price/RSI divergence developed in October/early-November and forecast the correction that followed, although not a major one and not leading to a trend reversal; at least we can't say yet that INTC has gone from a bullish trend to bearish. Stay tuned on that!

A bearish Price/RSI divergence is where prices are rising, but the RSI trend is not following suit as highlighted by the two diverging trendlines connecting the noted highs in both price and the RSI momentum indicator shown below in Home Depot (HD).

In both examples, that of a bullish Price/RSI divergence above and the bearish Price/RSI divergence pattern below, it's important to then WAIT for price action to CONFIRM (there's that word again!) a trend reversal. I just noticed that my HD chart illustration below was 'captured' a couple of days ago so the date and close is off slightly. No matter, as what I'm demonstrating is unaffected. HD Close today (12/31) was 26.94.

Speaking of WAITing, it's not necessary to wait for the just occasional instance of a bullish or bearish price/indicator divergence that comes along on a daily chart basis as such divergences are seen more frequently on hourly charts, especially in the indexes, using a 'length' setting of 21; i.e., measuring 21 hours of trading over a few day period.

For example, there was a substantial trading opportunity in DJX index calls presented by the rally that got underway in late-November as seen in the Dow (INDU) hourly chart below. I find that many if not most of the most powerful moves come after a bullish or bearish divergence (between price action and the RSI) that ALSO occurs by RSI readings in the typical 'oversold' area at or below 30-35 and the typical 'overbought' area of 65-70 in the 21-hour RSI.

After the first bullish price/RSI divergence highlighted (mid-November), a bearish divergence then set up a couple of weeks later after the strong run to the top. This divergence was, in turn, followed by a bullish divergence in mid-December. Lastly, the 4th and most recent divergence, a bearish one, didn't also occur accompanied by an overbought RSI extreme; I don't usually consider this pattern quite as 'strong' a trend reversal warning. Not like the chart following, of the S&P 500.

The SPX chart below shows its most recent 3 Price/RSI divergences: bearish, bullish, then bearish again. The reversals after the first two divergences led to reversal moves of around 70 and 50 points in SPX, respectively, before the trend shifted noticeably again.

The Nasdaq 100 (NDX) hourly and my last chart, has two key price/RSI divergences highlighted and those occurred well in advance of actual price reversals; all the more reason to have waited for price action to confirm a reversal by a trendline break or breakout. With the more volatile Nas 100 Index, putting more weight on buying puts at overbought extremes and calls on oversold extremes has made this aspect (overbought/oversold) of the 21-hour RSI indicator quite useful.

However, as with any indicator, I also caution against using overbought and oversold extremes strictly as a 'mechanical' trading trigger, as markets that get in a prolonged run can first get quite overbought (see the October period below) or oversold and thereafter have the trend continue to move substantially higher or lower. The time before a move really gets going can be obviously very important for those in long options also due to premium erosion in a sideways move; the sellers like these situations of course.

HAPPY NEW YEAR &
GOOD TRADING SUCCESS!
 

Trader's Corner Archives