Convergence and Divergence

Size: px

Start display at page:

Download "Convergence and Divergence"

Geoffrey Gibson
5 years ago
Views:

Convergence and Divergence Momentum: The Verge of Success Momentum plays a key role in trend analysis. Trends are composed of a series of price swings.

1 Convergence and Divergence Momentum: The Verge of Success Momentum plays a key role in trend analysis. Trends are composed of a series of price swings. It is a trader s edge to know when a trend is slowing down and then judge whether it is a trend consolidation or reversal. Price momentum refers to the direction and magnitude of price. The magnitude of momentum is measured by the length of short-term price swings. The beginning and end of each swing is established by structural price pivots which form swing highs and lows. Strong momentum is exhibited by a steep slope and a long price swing. Weak momentum is seen with a shallow slope and short price swing (Figure 1)..

2 Figure 1: Momentum Compare price swings to understand price momentum and then use the correct trading strategy for what price is doing. For example, the length of upswings in an uptrend can be compared. Longer upswings means the uptrend is showing increased momentum, or getting stronger. Shorter upswings signify weakening momentum and trend strength. Equal length upswings means the momentum is remaining the same. Price swings are not always easy to measure with the naked eye, especially since price can be choppy. Momentum indicators are commonly used to smooth out the price action and give a clearer picture of momentum. They allow the trader to compare the indicator swings to price swings, rather than having to compare price to price. Momentum Indicators Common momentum indicators include the Relative Strength Index (RSI), Stochastics, and Rate of Change (ROC). Figure 1 is an example of RSI used to measure momentum. The default setting for RSI is 14. RSI has fixed boundaries with values ranging from For each upswing in price, there is a similar upswing in RSI. When price swings down, RSI also swings down (Figure 2). Figure 2: Indicator swings generally follow the direction of price swings (A). Trendlines can be drawn on swing highs (B) and lows (C) to compare the momentum between price and the indicator.

3 This relationship can be taken a step further by comparing two price peaks to indicator peaks. This is accomplished by drawing a trendline between the two price peaks and another trendline between two corresponding indicator peaks (Figure 2). Changes in price momentum are seen when the slope of the indicator swing differs from the price swing. These changes are easily seen without the need to do any measurements. Less common is the ADX indicator, this is a measure of trend strength, as opposed to price strength. In the book ADXcellence, Dr. Schaap devotes a chapter to momentum. Trend momentum is the velocity of price of the overall trend and is measured by the sequence of ADX peaks. Compare the relative height of the ADX peaks when they are above 25. ADX is an excellent indicator for showing basic patterns of trend momentum. Figure 3: ADX quantifies trend momentum. When trend momentum is increasing, as seen in higher ADX peaks, we can us a trend trading strategy until something changes. When the two lines generally agree in slope, it is called momentum convergence. This is understood by imagining the indicator line overlaid on the price line; they would converge at a single point (Figure 3). In contrast, if the

4 indicator line slants down and away from price, it is called momentum divergence. Here, the two lines would diverge, each ending at a different point. Convergence Divergence Figure 4: Price momentum (green) compared to indicator momentum (red) Charles Schaap The study of momentum convergence and divergence checks if price and indicator agree or disagree, respectively. The amount of agreement/disagreement is relative, so there can be several different patterns that develop in the relationship between price and the indicator. Before I go on, let s make a quick review of trend: Higher pivot highs and higher pivot lows is an uptrend. Lower pivot highs and lower pivot lows is a down trend. Variable pivots highs and lows are sideways trend or range conditions. This is important as strategy is derived from price action. Divergence and convergence have different implications for trade management. There must be price swings of sufficient strength to make momentum analysis valid. Therefore, momentum is useful in active trends, but it is not useful in range conditions where price swings are limited.

5 Figure 5: New high in price. No new high in the indicator. Valid new Momentum Thrusts (breakouts) require that BOTH price and indicator make new highs If only one makes a new high, the trade will be jeopardy. This is taken directly from Dr. Charles B. Schaap s work in the book ADXcellence. Momentum Divergence Momentum divergence in an uptrend occurs when price makes a higher high, but the indicator does not make a higher high. In a downtrend, divergence occurs when price makes a lower low, but the indicator does not make a lower low. When divergence is spotted, there is a higher probability of a price retracement. Figure 6 is an example of loss of momentum and divergence, but not a reversal.

6 Figure 6: Momentum divergence and continuation of trend. Divergence helps you recognize and react appropriately to a change in price action. It tells us something is changing and to make a decision about the trade, i.e. tighten the stop-loss or take profit. Seeing divergence between price and the indicator increases profitability because there are times to protect profits. In an uptrend, divergence can be used as a signal to exit long positions, or sell covered calls; but it does not mean one should automatically go short. In Figure 6, the trend did not reverse (also see Figure 19). Divergence indicates that something is changing. The successful trader has no opinion about price but prepares for whatever direction price takes. Momentum is a clue to the right strategy at the right time. Divergence can lead to retracement, consolidation, or reversal. We don t have to predict, merely to be prepared. It is ego trading to want to call a top or bottom in price. A profit trader follows price to make money.

7 Figure 7: Signals for profit Momentum study can help you make the best use of time and money by having the right strategy at the right time. Let s take this chart of IBM (Figure 6). The left side of the chart we see higher highs and higher lows in price agree with higher highs and higher lows of MACD. This is a signal to trend trade, a trailing stop under swing lows. 1. Divergence is a warning that something is changing and the profit trader takes note. 2. A lower pivot high in price agrees with the lower high in the indicator. A strategy might be to sell a covered call or take partial profits. 3. The loss of momentum is not a trend reversal at this time. Trend can consolidate and continue or reverse. Indicators indicate. All indicators lag price because they are derived from price. The most important thing on any chart is price.

Figure 8: Divergence resulting in price range. When price and the indicator are inconsistent relative to each other we have disagreement, or divergence.

8 Figure 8: Divergence resulting in price range. When price and the indicator are inconsistent relative to each other we have disagreement, or divergence. We are not in control of what price will do; we control only our own actions. I must quote my husband here, Dr. Schaap, who says, The indicator is only useful if it signals something more than we can see with price alone. It is important not to have myriad indicators but to have a thorough understanding of the indicator you choose to use. In the two previous charts, the indicator was divergent from price and this gave warning that can preserve profits. A strategy might be to tighten the stop loss or sell a covered call. Price normally cycles between trend and range conditions, expansion and contraction. The best profits are made in trending conditions. Divergence does not mean reversal and often leads to sideways. A trend trading strategy is to trail a stop below previous price swing lows. Momentum strategies do not work out so well when there is consolidation or no trend. Convergence is very useful on breakouts from range. When price and the indicator both make higher highs together, (or lower lows together) there is a higher probability that the breakout is real.

9 Figure 9: Momentum confirmation at a new high in price, marked with green arrows. The trick in trading is to not get caught in the prediction game. We do not know what price will do and we do not need to know. Far more important and much less discussed is What is price doing right now and how do I profit? The professional trader does not predict, but prepares to profit from what price is doing. Know the answer to the question, Where is the profit opportunity and does the reward outweigh the risk. Momentum Convergence There is a saying - Let your profits run. Agreement between price and an indicator can show you how to do exactly that. Many traders focus only on divergence, while convergence between price and an indicator provides important signals. When we have convergence, let profits run! These principles apply to every time frame and any chart.

10 Figure 10: Five minute, ten year note (TY) chart with RSI. Red arrow is divergence. Green arrow is convergence, a signal to short. Source: GoFutures Convergence concepts for trend trading apply to every time frame, even the 5 minute futures chart of the ten year note. It is a very good strategy to follow price.

11 Figure 11: Daily Corn chart. Convergence of signals and price is a trend trade. Source: TradeStation When price is making higher highs and the indicator is also making higher highs, we have agreement, or convergence. When all parties are agreeable, it is a signal to continue with the plan. A trend trading strategy works when price is rising and the indicator is also rising. Convergence is an excellent trading signal. The best profits are made in trends and trends have agreement between the indicator and price. Any indicator used in technical analysis does not preempt price. The indicator adds information to what we see price doing. A trader need not be prescient, he needs to be prepared. A trading strategy is premised upon what price is doing

right now. If the price action changes, the trading strategy has to change to react to what price is doing at that time. Figure 12: Trend. Convergence, price and the indicator agree.

12 right now. If the price action changes, the trading strategy has to change to react to what price is doing at that time. Figure 12: Trend. Convergence, price and the indicator agree. Substantial price swings in the direction of the trend happen when price and the indicator agree. Figure 13: Convergence. Same chart as Figure 12 with a different indicator. Price remains the same. It is the understanding and use of the indicator that matters.

13 Figure 14: DMI measures Price Momentum. 1. Convergence, trend trade. 2. Divergence, protect profits. The trend did not reverse. It takes agreement between price and the indicator, convergence, to have any trend. (Trend hierarchy is covered in the Trend Master Series CD.) Have the Right Strategy at the Right Time Using the Indicator to Know What Trend Is Doing Much is made of divergence. But it is convergence between price and the indicator that signals the best trade opportunity. Convergence is confirmation and says to continue the strategy. Momentum divergence and convergence help frame out price action and identify changes in trend strength. This helps in trade management by letting the trader choose the right strategy for the conditions. You do not need to be prescient, just be prepared.

Any indicator used in technical analysis does not preempt price. The indicator adds information to what we see price doing, but all trading signals are based on price, not the indicator.

14 Any indicator used in technical analysis does not preempt price. The indicator adds information to what we see price doing, but all trading signals are based on price, not the indicator. Follow price for profits and use an indicator to confirm the strategy. Understanding momentum convergence enables the trader to stay with the best trends for the most profit, allow profits to run. And divergence signals decision time, when the trader may decide to take profits, tighten the stop-loss, or add a different strategy. Divergence can lead to another trading opportunity by having another strategy. Looking back at the chart in Figure 2, when there is convergence, continue the trade because you have an indication that price is going to continue what it is doing. Figure 3 and 4 show divergence and subsequently, price went lower. Divergence tells us something is changing and to make a decision about the trade, i.e. tighten the stop loss or take profit. The trend did not reverse and this is an important point. A trend reversal is not always presaged by divergence. Trends can continue or reverse. Divergence indicates that something is changing. We don t have to predict, we must prepare. Figure 14: Convergence, stay with the trend. At Divergence, the red arrows, selling a covered call is one strategy. The ADX Power Trend peak was the clue that the trend would continue.

15 Understanding momentum convergence enables the trader to stay with the best trends for the most profit. We always hear the term let profits run but if you can t identify a price trend, it is hard to let profits run. Profits are increased when we correctly navigate price fluctuations. It is not merely a target, but having the right strategy for what price is doing. Seeing divergence in price and the indicator increases profitability because there are times to protect profits. Divergence helps the trader recognize and react appropriately to a change in price action. Convergence and divergence frame out price action and proper identification and use of strategy for the best use of time and money. Price normally cycles between trend and range conditions, expansion and contraction. The best profits are made in trending conditions. A trend trading strategy is to trail a stop below previous price swing lows. This strategy does not work out so well when there is no trend. Figure 15: Convergence, green arrow, gives the trade signal. Pivot highs are price resistance. When price can not make a higher high, it has met resistance. In figure 8, the indicator confirms what we see price doing. At the red arrow we see no trend and the directional movement indicator is less than 25. The actual trade entry signal comes from agreement between price and the indicator. The lower high in price and DMI dominant and rising, signals a short entry.

Figure 16: A reversal. Divergence does not mean reversal. Triangles are formed of variable pivot highs and lows and the best trade is to wait for a signal out of the triangle.

16 Figure 16: A reversal. Divergence does not mean reversal. Triangles are formed of variable pivot highs and lows and the best trade is to wait for a signal out of the triangle. In this example, after the break of price support (green arrow) agreement of the indicator and price indicate a short trade entry and the reversal to down. Trends do not change direction quickly or often.

Figure 17: Bear Stearns chart shows Distribution phase for 8 months before momentum picked up and the trend reversed. The red arrow shows convergence of price and indicator. Indicators indicate.

17 Figure 17: Bear Stearns chart shows Distribution phase for 8 months before momentum picked up and the trend reversed. The red arrow shows convergence of price and indicator. Indicators indicate. All indicators lag price because they are derived from price. The most important thing on any chart is price. Structural pivots are price formations, structural pivots are real time price signals. Reading pivots will help you spot trends and use them to your advantage.

18 Figure 18: A trend. The red line is divergence which did not lead to a reversal. The green lines are convergence. The more important information is the blue trendline drawn on pivot lows to show the long term uptrend. There were opportunities to have a short term profit opportunity within the overall long term trend. Letting profits run means staying with the trend for the best use of time and money. This chart is a case of the indicator not adding to the information we get from price alone. If the indicator doesn t add to what we know from price, I say fire it! The trader s job is 1.) To preserve capital. 2.) To make a profit. Nothing else is required. It is not the trader s job to wonder about things, to imagine or predict events. It is the trader s job to make money. We make money when we have a strategy for profit. When using signals that are clear and consistent, the odds for a high return are better. The END By Candy Schaap The concepts presented in this article derive from the work of Dr. Charles B. Schaap. Chapter 6 of the book, ADXcellence: Power Trend Strategies, covers trend and price momentum. Candy Schaap and husband, Dr. Charles B. Schaap are a trading team. Candy started her career hedging futures for a large corporation and has 25 years of trading experience in futures, options, stocks and bonds. She does consulting, lecturing and writes financial articles.

Figure 3.6 Swing High

Figure 3.6 Swing High Swing Highs and Lows A swing high is simply any turning point where rising price changes to falling price. I define a swing high (SH) as a price bar high, preceded by two lower highs (LH) and followed