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Blog / Divergences on the Stock Market

Divergences on the Stock Market

2011/03/01. - 13:00

 

Divergences might play a very important role in the decision of the professional trader.

For this reason I  touch this topic briefly  to  help and encourage  traders  to  learn more about  divergences and their applicability.

Divergences  are  certain patterns, that  show up  in the relationship of two charts, usually  one price chart and  one indicator chart or  the price charft of another  asset.

Divergences can be identified on  different  time-frames, be that one minute time frame, 5 minute time frame,

Hourly, daily, weekly or monthly time frame.

Divergences  can be considered  as pre warning signals and   Not as trading signals,  and tell us that the  current  direction of the price, the current trend might be about change.

Usually  the higher the time frame and the higher the divergence   the greater the probability  that a specific divergence  will be a trigger  for a real trend change.

As the indicator,  that is compared to the price charts, the most often used ones are:

-          MACD, Breath indicators,  Momentum indicators, CCI, RSI, PMO, TICK...

We can categorize the  divergences  as follows:

-          Regular Bullish divergence.

-          Regular Bearish divergence.

-          Hidden Bullish divergence.

-          Hidden Bearish divergence.

Regular divergences are often precursors of  pending trend direction changes, while  hidden divergences are precursos of trend – continuations.

Probably the most often used one is the  Bullish regular  divergence,  since  most market players are trend following  Bullish  players and  they would like to  get  into the market  at lower proices  while the trend is in their  preferred direction.

You can  find  description of these  divergences  for the regular divergences HERE and for the hidden divergences  HERE.

Some of the most important market turns  in the indices  during the  past  few years preceded by   very telling divergences.

Some of theser were  (Looking at the S&P5000  daily chart):

 -    March 9-th   2009  we had a  big  Bullish regular divergence  on the Daily price charts, compared to  the  MACD indicator  (As one example) and it turned out to be  a  long-term market bottom.

-     One of the latest  notable regular  Bullish divergence occurred   July 6-th 2010, which was the precursor of a  long rally, that is still in place after   almost 8 month.

-     One very interesting Hidden Bullish divergence occurred on  July 9-th 2009, when the  S&P500 index made a higer low, but the MACD indicater made a lower low.

We do not need to constantly  be  on the lookout for divergences to  find proimising one  while we are focusing on  market activity and  potential  future direction.

The only time, when we need to  check  potential divergences are only the following situations:

1          When price formed a Higher high on our time frame  (For example on the Daily chart the prices formed a  new 10 – 20 day high. The bigger  the number of days, the better.)

2         When price formed a lower low  on our time – frame. (For example on the Daily chart the prices formed a  new 10 – 20 day low.)

3         Price formed a double top. (Looking at Daily time  chart, it is  more significant, if the tops  are more than a few days  apart from each other.)

4         Price formed a double  bottom.

For the pfredictionwizard  users  probably the most often used time-frames  will be the 5 minute, the hourly and the Daily time – frames,  that will need to be screened for divergences, but we can’t expect big  reversals  looking at the 5 minute divergences.

To  make the real trading decisions we  need to consider  divergences only as warning signal or flashing signals, but not as trading signals alone.

But complemented  with  some other technical analysis it can be real  beneficial. (Confirmed trend change,  Volume analysis, other indicator  status...)

Very often we get additional  supporting information  as confirmation  looking at  market activity. For example  before  Bullish reversals  we might have a so-called exhaustion, when  sellers pushed down prices  quickly  on heavy volume before, but the  selling pressure eased   by the time the previous minimum  retested, presenting a Bullish regular divergence, and the market soon turns upward.

Assuming that  our selected time-frame is  X (Time  unit) and we pinpoint a regular divergence.  Question could  be how long would it take for the market to work  off that divergence.  It might  happen within 2 – 5 * X or 2 – 5 times the selected time-frame if a regular  divergence does not lead to a trend direction change.  So for example  we detected a  regular divergence on the Daily chart of the S&P500 and  would like to know,  how  long could it be played.   If we enter the market 3 – 5 days (3 – 5 *X  time-frame unit ) later, than  it might be late and we might have missed completelly the  market movement,  triggered by  the divergence.

For those, who have  good programming skills,  the creation of a so-called auto–divergence–finder  might not be a difficult  task to do.

What is  the mass psyhology behind the divergences?

Imagine that  after the eruptin of a sudden  Bearish  event, the  market participants  panic,  and quickly sell off the market on heavy volume,  creating a  strong Bearish  momentum. The market quickly   regain ground,  and some of the market players, who missed the first  opportunity to get long, decide to enter the market the next time,  it  approaches  the previous low levels.  The  bigger the time – difference from the  sudden  market low, when the strong selloff first occurred, the more market players  might  be ready to enter on the long side again.  The market might reach a new low  on  lower volume, when the divergence occurs, and  suddenly those Bullish players  pull up the market,  working off the  divergence.

The extent of the move,  following the divergence  can’t be estimated  just based on the particularities of the divergence.  It is much better  to use   other target  estimation methods, like Fibonacci  levels,  support – resistance analysis...

Some of the pro traders  having a lot of  experience  can  identify  market turning  situations without consciously  or explicitelly  looking  at  indicators.  They have a feel for the market. The application of that hidden, unconscious knowledge happens  extremely quickly  during  trading decisions.

People used to say that price and volume contains all the information. But untrained eye can’t  pinpoint  areas,  on a chart, that  is highlighted  by the indicators,  derived from price.  Only one example is the areas  of  those  divergences.

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