IT is not as simple as people think it is. Divergence is the idea that since the oscillator (whatever it is – RSI, stochastic, MACD etc.) measures momentum, if price tries to make a new high, but the oscillator doesn’t, there is insufficient momentum in that move and the trend is about to reverse.
You are only seeing one side of the coin.
Let me start by saying I trade divergences. I LOVE divergences – they are an important part of my trading arsenal. But alone, they can get you into all kinds of trouble. If you don’t know what a divergence is or need to refresh your memory, here’s a quick and easy review:
Fully revised? Okay, let’s look at the two faces of reversal (or “regular”) divergence. We will ignore “hidden” or continuation divergence for this post.
THE TALE OF THE DIVERGENCE TRADERS, MR. PRICE AND THE BEAR
Let’s pretend we are watching someone named Price climb a hill. His steps are nice and steady and every step is moving him higher and higher. Suddenly, we see him take a smaller-than-normal step. What’s up with that? He’s lost some momentum.
At this point, trigger-happy divergence traders will say “Yay! He’s going to turn around. Let’s sell!” and pop open a bottle of champagne.
Yeah right. He’s only stopping to take a breath. He pauses for a moment, then continues on for a few more steps before slowing down again.
“We’ve got him now!” the divergence chorus goes. “That fella’s going down!”
Nope. He needed a drink that time. The intrepid Mr. Price continues up.
“He’s gotta turn SOMEWHERE!” the frustrated traders go. “We’ll get him the next time for sure.”
So when the guy’s momentum slows, they try selling the move down again. Well, remember the little engine that could? This guy does too. He continues chugging up…”I think I can, I think I can!”
“This market’s impossible!” the thrice-burnt divergence traders cry. And they all go home to lick their wounds in disgust.
Mr. Price continues along for awhile until he gets to a cave. Suddenly, his steps lose momentum again. There is one sharp little trader who refused to sell with the pack. He has been waiting for Mr. Price to find that cave. Now, as momentum slows, he carefully prepares to sell the market. The steps become tentative as our traveller pushes on, “I think I can, I think I can!” until suddenly, a huge ROAR comes from deep within the cave, and out emerges a BIG, BROWN BEAR.
In terror, Mr. Price turns around and runs down the hill as quick as his legs can carry him, scurrying for the safety of home. And the sharp little trader? He sold the market 2 seconds after Mr. Price met the bear, and made a killing in the market. He trots on home whistling a happy tune. The End.
Here’s the moral of the story:
If you sell (or buy, depending on the direction) every divergence just because it shows price is losing momentum, you may lose a lot of money. On the other hand, if you can figure out where the bears are hiding to end an uptrend, or where the bulls are hiding to end a downtrend, you can do very nicely for yourself.
With best wishes for your trading,
Private Fund Trader/Head Trader Consultant
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