Monday, December 16, 2013

Divergence and the Parting of Ways

RSI and Stochastics are perhaps the two most popular indicators.  I think part of the appeal lies in the simplicity of their interpretation. Buy when they are oversold level and turnup and sell when they are overbought and turn down.  However the performance of these indicators can be improved by introducing divergence analysis into the mix.  

Simply put, divergence is a “parting of ways” between prices and indicators.  Bullish divergence occurs when prices move down as the indicator moves up (see the green trendlines below).  Bearish divergence is just the opposite; prices continue up as the indicator turns down (see the red trendlines).

In the chart above, the RSI crossed above 30 at point B1.  This represents a typical point where a buy trade based on a traditional oversold signal would occur.  The corresponding sell signal would have occurred at point S1 when prices crossed below 70.   However, by waiting for a divergence confirmation at points B2 and S2, both the entry and exit could have been improved.

So take a look at your trading systems that have overbought/oversold-based signals and consider parting with tradition by introducing a bit of divergence.    

No comments: