Finding Hidden Setups Using Advanced Divergence Strategies
Trading divergences has been a
cornerstone of my trading for some time. I
just love to find setups where the stock might be saying one thing while either
the market or the stock’s technicals is saying something else.
It kind of reminds me of a politician during election time.
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I like to look for two types of divergences:
- Stocks
that diverge from broad-based market or sector indices
- Stocks
that diverge from price oscillators
For the first type of
divergences, I look for stocks that are weaker or stronger than the general
market and/or their respective sector indices. The
strongest stocks are the ones that go up while the market is going down.
In this case, the stock is said to have a positive
divergence with the
market. For example, if a stock can buck
a downtrend and move higher in a market like this, something must be very
special. Therefore,
you would definitely want to keep that one on your radar as a long candidate.
On the other hand, the weakest
ones are the ones that go down while the market is moving up.
In other words, the stock has a negative
divergence with the market.
Conversely, when the general market is moving higher and higher, but a
stock is not following or is moving lower, the “smart money†is distributing
the stock. That stock could be a good
short candidate.
Here’s how you can search for
these types of divergences:
- One
way to look for these stocks is to use some type of charting software such
as TC2000, Metastock or Supercharts. Plot
the stock on top and an index or sector index on the bottom.
Sift through the charts in your database.
On days the market is down, pay special attention to the
stocks that are bucking the trend and are moving up.
These are the strongest stocks, and these are most likely to continue
to move higher. Yes, going through
hundreds and perhaps thousands of stocks can be a long and tedious process.
However, there’s a good chance that you’ll uncover some gems that have
been overlooked by the financial media. The
stocks that are consistently bucking the trend are the strongest (weakest
for shorts), and they are the ones that you should be trading.
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- Another
way is to look at the top gainers or losers list.
On a day where the market is down, look at the top gainers list. If the stock is
consistently on the top gainers list while the market is down, pay attention
to that one. And if a stock is
consistently on the point losers’ side while the market is up, you may want
it on your short list.
Generally, I prefer the first
way because it lets me see the divergence visually. I also like to draw trendlines on
both the stock chart and index chart. Since
I consider myself a swing to intermediate-term trader, I would like to see a
stock diverge for at least three to five days. And
preferably, the stock has taken out some important resistance.
I seldom base a trade solely off a divergence. Rather, the divergence is
used as a “heads up.” Â
Let’s
look at a couple of examples:
For the second type of
divergence, I like to look for stocks that have made a new swing high or swing
low. I would then look at certain price
oscillators to check and see if their moves are confirmed by the price
oscillators. If they are not, this tells
me that the moves are unsustainable and some type of a pullback or reversal will
likely occur.
The oscillators I use are:
- Momentum
— momentum is really a rate-of-change indicator.
It compares the stock’s current close to the close of some number
of days ago. As long as a stock
closes higher and higher and by a greater amount each day, the momentum is
increasing. However, as that rate of
change starts to slow, momentum decreases and a pullback or reversal is
likely to follow. Think of launching
a model rocket. The start of the
launch has the most momentum as the rocket gets off the ground.
As the rocket goes higher and higher, at some point it will run out
of momentum and head back down. It’s
kind of the same for a stock.
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- RSI
— The RSI, or Relative Strength Index, is a price oscillator that compares
the stock’s up closes to down closes over a number of days.
Typically, it’s used to identify overbought and oversold levels,
but I prefer to use it to spot divergences.
For instance, when a stock
makes a run to the upside and makes a short-term For these indicators, pay special
attention to:
- A
stock that rises, but the momentum or RSI is falling (Negative Divergence)
- A
stock that falls, but the momentum or RSI is rising (Positive Divergence)
Typically, I would like to see
a divergence in both indicators, as that adds more weight to the evidence.
However, sometimes one is enough. So
how do you know which divergences to trade? Well,
first, to help you see the divergence, you need to draw some trendlines.
Draw trendlines on:
- Prices
— Draw trendlines connecting the prior high to the new high or prior low
to new low
- Momentum
Indicator – Draw trendlines connecting the prior high to the new high or
prior low to new low
- RSI
– Draw trendlines connecting the prior high to the new high or prior low to
new low
The most important thing to
look at is the size of the divergence as measured by the steepness of the
trendlines. The steeper the angles of the
trendlines, the greater the divergence between price and the oscillator.
Let’s look a few examples:
In conclusion, adding
divergence analysis to your arsenal can help you:
1.
Spot the strongest or weakest stocks in the market.
2.
Identify potential pullbacks or reversals.
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