Spotting Trend Reversals
Trading Medium-Term Divergences
Detect medium-term divergences by using the zero-lagging exponential moving average, support and resistance lines, and trendlines.
When a stock price and an oscillator move in the same direction it's known as a convergence. When price and oscillator move in opposite directions, it's known as a divergence. In looking at the lows of the oscillator and comparing them with the lows in price, we can define three different situations (see Figure 1):
- When the price and oscillator make higher or equal bottoms, they converge. Until there is no other indication, the most probable price move is a continuation of the uptrend.
- When the oscillator creates a higher bottom while the price makes a lower bottom, they diverge. This is mostly found at the end of a downtrend, indicating an uptrend reversal.
- When the oscillator has a lower bottom while the price sets a higher bottom, they diverge. This is mostly found in a price uptrend after a price correction, indicating a continuation of the uptrend.
FIGURE 1: COMPARING PRICE AND OSCILLATOR BOTTOMS. Here you see the three different scenarios at price and oscillator bottoms.
Simply looking at bottoms, we can say that the price is going to move up if there is a divergence between the price and the oscillator or if the price and the oscillator bottoms converge in an uptrend.
Looking at the highs of the oscillator and comparing them with highs in price, we can define three other situations (see Figure 2):
- When the price and the oscillator make equal or lower tops, they converge. Until there is no other indication, the most probable price move is a continuation of the downtrend.
- When the oscillator makes a lower top while price makes a higher top, they diverge. This is mostly found at the end of an uptrend, indicating a downtrend reversal.
- When the oscillator makes a higher top while price makes a lower top, they diverge. This is usually found in a price downtrend after a price up correction, indicating a continuation of the downtrend.
Excerpted from an article originally published in the February 2008
issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2008, Technical Analysis, Inc.
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