When going through the timeline last night I came across a post from @AnneMarieTrades that I found interesting:
“Folks, momentum is SLOWING – it dsnt mean we r rolling over. Observe divergence- but don’t trade divergence. Trade price, & price alone $$”
I always like to look for divergences in price with indicators such as the popular MACD, Momentum, or RSI. When I first started trading I read in books that these can be warning signs. So what did I do? Naturally I traded against the trend and in the direction of the divergence that the indicator was pointing to (often at tops calling for downside). Needless to say I lost more money than I made. Sure there were some hits and the psychological feeling was great but I lost more often than I won.
Then I watched a presentation by Linda Bradford Rashke and she stated that when most people trade divergence they fail to look at the higher time frame. This is exactly what I failed to do and needless to say I was usually trading against what was a powerful uptrend. So if you are trading a daily chart and there is a divergence, look at the weekly and what is that telling you? Same goes if you are trading a 5min, look at the 30min; and if you are trading a 30min, look at the 240min or daily. I am quite certain you will be surprised at how often you are trading against the bigger picture. Sure you may catch a top or bottom here or there but those profits will probably go back into the market to the other side. Now divergences are more of an observation than a trade for me.
Posted below is a daily chart with the Momentum Oscillator, MACD, and MACD histogram (difference below the two lines). While many traders like the MACD histogram (bottom pane), I personally do not use it and instead focus on the MACD (middle pane) by putting the Value as a histogram (purple) and the Avg as the line (yellow). If the histogram (purple) is above zero, then it is a bullish signal. Also I will look for divergences on that histogram alone more so than the MACD histogram (bottom pane). Below is a picture of the daily chart of the SPX, note that MACD (purple histogram) has not shown a divergence like the MACD Historgam (bottom pane) has:
Here is the Weekly chart showing the same time frame, highlighted in blue. I left the lines on price to show as a reference to where they were on the daily:
While the daily is showing a divergence, the weekly is showing a powerful uptrend. While many can trade the divergence or scale down to a lower timeframe for day/swing trades then that is great as there can be some homeruns with a good entry and scaling plan. My goal here was to highlight that higher time frame, no matter what time frame you trade on.
2 Responses to Thoughts on Divergences
Excellent take on the use of divergences. Yes, price action is king; nevertheless lower time frame price/momentum divergence often gives you clue in the underlying “tone” of the price action. Combine divergence, price action behavior around resistance and support area, and popular chart pattern (candlestick or patterns such as H&S, flag, traingle), you have a powerful tool to help you execute your decision without hesitation.
Sometimes, the occurrence of a divergence can also mean time to take a break since momentum is slowing; especially when you are swing trading in the time frame where the divergence occurs.
In summary, divergence is just another tool for any trader to build confidence in executing a decision. As in any trading tool, it is best to have confirmation from other tools such as price action.
Thanks for sharing.
Good point in that it is a useful tool to be coupled with other technicals.
As you mentioned to it can be just a break in momentum. I think that this is where some can get confused as the trend may still be intact but just taking a breather. Thanks for the useful comments zen.