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February 7, 2013 / redman59

Thoughts on Divergences

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:

spx_20130207

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:

spx_20130207aWhile 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.

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