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Divergence: The Trade Most Profitable

By Candy Schaap

Because trends are composed of a series of price swings, momentum plays a key role is assessing
trend strength. As such, it is important to know when a trend is slowing down. Less momentum
does not always lead to a reversal, but it does signal that something is changing, and that the
trend may consolidate or reverse.

Price momentum refers to the direction and magnitude of price. Comparing price swings helps
traders gain insight into price momentum. Here, we'll take a look at how to evaluate price
momentum and show you what divergence in momentum can tell you about the direction of a
trend.

Tutorial: Analyzing Chart Patterns

Defining Price Momentum


The magnitude of price 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).

Figure 1:
Momentum

For example, the length of the upswings in an uptrend can be measured. Longer upswings
suggest that the uptrend is showing increased momentum, or getting stronger. Shorter upswings
signify weakening momentum and trend strength. Equal length upswings means the momentum
remains the same. (For related reading, see Momentum Trading With Discipline and Riding The
Momentum Investing Wave.)
Price swings are not always easy to evaluate with the naked eye - price can be choppy.
Momentum indicators are commonly used to smooth out the price action and give a clearer
picture. 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 for measuring price movements include the relative strength
index (RSI), stochastics and rate of change (ROC). Figure 2 is an example of how RSI is used to
measure momentum. The default setting for RSI is 14. RSI has fixed boundaries with values
ranging from 0-100.

For each upswing in price, there is a similar upswing in RSI. When price swings down, RSI also
swings down. (For related reading, see Getting Confirmation With The Momentum Strategy.)

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.
Source: TDAmeritrade
Strategy Desk

The study of momentum simply checks whether price and the indicator agree or disagree.
Figure 3: Compare price
and indicator to make
better trading decisions.
Source: TDAmeritrade
Strategy Desk

Momentum Divergence
Disagreement between the indicator and price is called divergence, and it can have significant
implications for trade management. The amount of agreement/disagreement is relative, so there
can be several different patterns that develop in the relationship between price and the indicator.
For this article, the discussion will be limited to the basic forms of divergence. (For more, see
What does it mean to use technical divergence in trading?)

It is important to note that 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 in which price swings are limited and variable, as shown in Figure 4.
Figure 4: In range
conditions the indicator
does not add to what we
see from price alone.
Variable pivot highs and
lows show range.
Source: TDAmeritrade
Strategy Desk

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 5 is an example of divergence and not a reversal, but a change of
trend direction to sideways. (For more insight, check out Retracement Or Reversal: Know The
Difference.)
Figure 5: Momentum
divergence and a
pullback. Higher pivot
highs (small orange
arrows) signal price
support.
Source: TDAmeritrade
Strategy Desk

Divergence helps the trader recognize and react appropriately to a change in price action. It tells
us something is changing and that the trader must make a decision about the trade, such as
tighten the stop-loss or take profit. Seeing divergence increases profitability by alerting the trader
to protect profits.

Take note of the stock from Figure 5, Chesapeake Energy Corp. (NYSE:CHK), in which shares
pulled back to the support. The chart of CHK in Figure 6 (below) shows that trends do not
reverse quickly, or often. Therefore, we make the best profits when we understand trend
momentum and use it for the right strategy at the right time.
Figure 6: Trend
continuation. Agreement
between price and the
indicator give an entry
(small green arrows).
Source: TDAmeritrade
Strategy Desk

Managing Divergence
Divergence is important for trade management. In Figure 5, taking profit or selling a call option
were fine strategies. The divergence between the price and the indicator lead to a pullback and
then the trend continued. If you look at the pivot the price makes below the lower trendline, this
is often referred to as a bear trap, where the false signal draws in shorts and then price quickly
reverses. We can see that the signal to enter appeared when the higher low in price agreed with
the higher low of the indicator in Figure 6 (small green arrows).

Divergence indicates that something is changing, but it does not mean the trend will reverse. It
signals that the trader must consider strategy options: holding, selling a covered call, tightening
the stop or taking partial profits. The glamor of wanting to pick the top or bottom is more about
ego than profits. To be consistently profitable is to pick the right strategy for what price is doing,
not what we think price will do. (For more, see Divergences, Momentum And Rate Of Change.)
Figure 7: Divergence
results in range.
Source: TDAmeritrade
Strategy Desk

Figure 7 shows divergence that leads to sideways price action. Notice the weakening momentum
in moving average convergence divergence (MACD) as price enters a range. This signals that the
trader should consider strategy options. 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.

Figure 8: Divergence and


then reversal of trend.
Source: TDAmeritrade
Strategy Desk

Sometimes divergence will lead to a trend reversal, as shown in Figure 8. The Utilities Select
Sector SPDR (ARCA:XLU) shown in Figure 9 pays a dividend and has options. Understanding
trend momentum gives a profit edge, as there are three ways to profit here: capital gains,
dividends and call premium. This example shows trend continuation after a sideways move,
which translates into profit continuation.

Figure 9: Go with the


trend when the price and
the indicator agree.
Source: TDAmeritrade
Strategy Desk

Conclusion
The most useful way to use a momentum indicator is to know what strategy to use. Price will
lead the way but momentum can indicate a time to preserve profits. The skill of a professional
trader lies in his or her ability to implement the correct strategy for price action.

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