Divergence: The Trade Most Profitable By Candy Schaap Because trends are composed of a series of price swings, momentum momentum plays plays a key role is assessing trend strength. trend strength. As such, it is important to know when a trend is slowing down. Less momentum does not always lead to a reversal reversal,, but it does signal that something is changing, and that the trend may consolidate or reverse. Price momentum refers to the direction and magnitude of price. Comparing price swings helps traders gain insight into price momentum. ere, we!ll take a look at how to evaluate price momentum and show you what divergence in momentum can tell you about abo ut the direction of a trend. Tutorial: Analyzing Chart Patterns Defining Price Momentum "he magnitude of price momentum is measured by the length of short#term price swings. "he beginning and end of each swing is established by structural price pivots, which form swing highs and highs and lows lows.. Strong momentum is e$hibited by a steep slope and a long price swing. %eak momentum is seen with a shallow slope and short price swing &'igure ().
'igure (* +omentum 'or e$ample, the length of the upswings in an uptrend can be measured. Longer upswings suggest that the uptrend is showing increased momentum, or getting stronger. Shorter upswings signify weakening momentum and trend strength. -ua l length upswings means the momentum remains the same. &'or related reading, see Momentum see Momentum Trading Trading With With Discipline and Riding and Riding The Momentum Investing Wave Wave.) .)
Price swings are not always easy to evaluate with the naked eye # price can be choppy. +omentum indicators are commonly used to smooth out the price action and give a clearer picture. "hey allow the trader to compare the indicator swings to price swings, rather than having to compare price to price. Momentum Indicators Common momentum indicators for measuring price movements include the relative strength inde$ &S/), stochastics and rate of change &0C). 'igure 1 is an e$ample of how S/ is used to measure momentum. "he default setting for S/ is (2. S/ has fi$ed boundaries with values ranging from 3#(33.
'or each upswing in price, there is a similar upswing in S/. %hen price swings down, S/ also swings down. &'or related reading, see Getting Confirmation With The Momentum Strategy.)
'igure 1* /ndicator swings generally follow the direction of price swings &A). "rendlines can be drawn on swing highs &B) and lows &C) to compare the momentum between price and the indicator. Source* "4Ameritrade Strategy 4esk "he study of momentum simply checks whether price and the indicator agree or disagree.
'igure 5* Compare price and indicator to make better trading decisions. Source* "4Ameritrade Strategy 4esk Momentum Divergence 4isagreement between the indicator and price is called divergence, and it can have significant implications for trade management. "he amount of agreement6disagreement is relative, so there can be several different patterns that develop in the relationship between price and the indicator. 'or this article, the discussion will be limited to the basic forms of divergence. &'or more, see What does it mean to use technical divergence in trading?)
/t is important to note that there must be price swings of sufficient strength to make momentum analysis valid. "herefore, momentum is useful in active trends, but it is not useful in range conditions in which price swings are limited and variable, as shown in 'igure 2.
'igure 2* /n range conditions the indicator does not add to what we see from price alone. 7ariable pivot highs and lows show range. Source* "4Ameritrade Strategy 4esk
4ivergence in an uptrend occurs when price makes a higher high, but the indicator does not make a higher high. /n a downtrend, divergence occurs when price makes a lower low, but the indicator does not make a lower low. %hen divergence is spotted, there is a higher probability of a price retracement. 'igure 8 is an e$ample of divergence and not a reversal, but a change of trend direction to sideways. &'or more insight, check out Retracement Or Reversal !no" The Difference.)
'igure 8* +omentum divergence and a pullback. igher pivot highs &small orange arrows) signal price support. Source* "4Ameritrade Strategy 4esk 4ivergence helps the trader recogni9e and react appropriately to a change in price action. /t tells us something is changing and that the trader must make a decision about the trade, such as tighten the stop#loss or take profit. Seeing divergence increases profitability by alerting the trader to protect profits. "ake note of the stock from 'igure 8, Chesapeake nergy Corp. &:;S*C< ), in which shares pulled back to the support. "he chart of C< in 'igure = &below) shows that trends do not reverse -uickly, or often. "herefore, we make the best profits when we understand trend momentum and use it for the right strategy at the right time.
'igure =* "rend continuation. Agreement between price and the indicator give an entry &small green arrows). Source* "4Ameritrade Strategy 4esk Managing Divergence 4ivergence is important for trade management. /n 'igure 8, taking profit or selling a call option were fine strategies. "he divergence between the price and the indicator lead to a pullback and then the trend continued. /f you look at the pivot the price makes below the lower trendline, this is often referred to as a bear trap, where the false signal draws in shorts and then price -uickly reverses. %e can see that the signal to enter appeared when the higher low in price agreed with the higher low of the indicator in 'igure = &small green arrows).
4ivergence indicates that something is changing, but it does not mean the trend will reverse. /t signals that the trader must consider strategy options* holding, selling a covered call, tightening the stop or taking partial profits. "he glamor of wanting to pick the top or bottom is more about ego than profits. "o be consistently profitable is to pick the right strategy for what price is doing, not what we think price will do. &'or more, see Divergences# Momentum $nd Rate Of Change.)
'igure >* 4ivergence results in range. Source* "4Ameritrade Strategy 4esk 'igure > shows divergence that leads to sideways price ac tion. :otice the weakening momentum in moving average convergence divergence &+AC4) as price enters a range. "his signals that the trader should consider strategy options. %hen price and the indicator a re inconsistent relative to each other, we have disagreement, or divergence. %e are not in control of what price will do? we control only our own actions.
'igure @* 4ivergence and
then reversal of trend. Source* "4Ameritrade Strategy 4esk
Sometimes divergence will lead to a trend reversal, as shown in 'igure @. "he tilities Select Sector SP4 &ACA*L) shown in 'igure pays a dividend and has options. nderstanding trend momentum gives a profit edge, as there are three ways to profit here* capital gains, dividends and call premium. "his e$ample shows trend continuation after a sideways move, which translates into profit continuation.
'igure * Do with the trend when the price and the indicator agree. Source* "4Ameritrade Strategy 4esk Conclusion "he most useful way to use a momentum indicator is to know what strategy to use. Price will lead the way but momentum can indicate a time to preserve profits. "he skill of a p rofessional trader lies in his or her ability to implement the correct strategy for p rice action.
