........2a...DIVERGENCES


   ☞ PRICE to INDICATOR  DIVERGENCE☜ ☜    

A very important part of my trading style

 An indicator usually shows a close correlation between it's highs & lows 
to those of prices. When an indicator does not mimic price, it is displaying divergence.

Divergence indicates the possibility of an imminent change in price direction.
 It does not necessarily tell me how strong that change may turn out to be, when exactly it will occur nor does it tell me whether price 
will change to the opposite direction or to just change temporarily to sideways before continuing to go in the direction it was.
Interpreting divergences between price and what you'd expect to see in the indicators allows you to anticipate 
a change that has not yet happened to the price...i.e. you extrapolate what may next happen with price.
Proper interpretation of price to indicator divergence lets you front run potential reversals which means better entry points.
Note that I see reversals as a matter of course...my T/A bias is always bullish
All indicators LAG price action because they are based on prices that have already happened.
Interpreting what indicators are doing relative to prices is what makes them useful.
 IMO, divergences are the closest we can get to a leading indicator.

Before and after sets -- divergences telling you that a down trend is about to end.


Trend lines and divergences

Patterns and divergences

Divergences may develop on more than one time frame simultaneously.
Divergences with indicator signals
(either MACD or TRIX can be used...combined with stochastic)

REVERSALS RULE !

DIVERGENCE TYPES
The notes and annotations on the charts that follow explain how I define the different types of divergences that are mentioned throughout this blog.

 In the study pane the diagonal divergence lines are drawn for the blue TRIX histogram - sometimes the yellow Stochastic line is also divergent near the same point as the histogram (2x Divergence). On occasion the blue and/or red MACD ema lines will also show divergence (3xD)...When all three indicators show divergence near the same price point, it gives you very strong rational for expecting an imminent change in price direction.

 To identify divergences, I compare adjacent extremes in the histogram that are on the same side of the study center line. Usually  there will be a single move in the histogram bars to the opposite side of the center line in between the adjacent extremes. I've marked these divergences in the study pane of the chart below using aqua, orange and lime diagonal lines with corresponding lines drawn in the price pane for each divergence.


My personal preference for identifying divergence is to favor studies that are considered to be indicators of trend.
I use MACD or TRIX histograms more so than their plotted moving average lines.

 But I also consider that histogram shapes, or their slopes in particular can show divergence relative to price. 
This happens when the slope is moving in the opposite direction of price. 
The chart below is a view of the difference between 'normal' histogram divergence and Slope divergence.


 I use a sloping histogram as a leading signal...it can indicate that the intensity 
of the current price movement is diminishing and likely to end or reverse soon...


I will often use a sloping histogram that occurs in the bottom half of study panes as a rational to enter new Long positions.
I will sometimes use a sloping histogram that occurs in the upper half of study panes to exit an existing Long position.
But I do not use divergences that occur in the upper half of study panes as a rational for taking Short positions.

 ANOTHER LOOK AT DIVERGENCES
Here the divergence types are marked in the price pane by the vertical lines and are identified by the diagonal lines in the study pane.
 Div -  Price making LL, MACDh making HL
Hidden Div -  Price making HL, MACDh making LL
Reversing Div -  Price making HH, MACDh making LH 

NQ 120 tick chart spanning about two hours of price action.


10/4/2013 Hidden Divergence
I sometimes inter-change the terms Reverse and Hidden divergence...Reverse or Hidden divergence is used as a continuation signal 
of the trend that was in place before a pull-back occurs...that is, it reverses the pull-back and continues the longer, overall trend. 

 The 5 minute e-mini charts below show 'Hidden' divergence because prices made HL's while the indicators made LL's. 
This suggests that the immediately preceding down turn (pull-back) was over-done - so expect the previous up trend to resume. 
Notice too that all three markets printed the pattern simultaneously.


3/4/2013 "Reversing" Divergence at Tops 
 -  Price making HH's while indicators are making LH's - 
 Reversing divergence can be a warning that an up trend may be nearing its end.

It is different than Reverse divergence, which is a continuation signal for the over-all trend and happens during an up trend
Admittedly,  the distinction is a bit confusing...
 I define any divergence as the potential for imminent trend change. The difference between these two similarly named types is :
Reversing divergence shows up in the upper half of the study
Reverse divergence develops in the lower half of the study.

 Reversing divergences form frequently while price is in an up trend. My experience has shown me that as reversal signals, they are
 not very reliable at calling a trend change. Comparing statistics, using Reversing divergence as a trading signal for entering short positions
 does not work nearly as often as does using Regular divergence signals for entering long positions.  
 I place less trust in divergences when they occur above a study's center line than those occurring below the center line.

I find it more difficult to call a top, thus my preference for long trades
  I infrequently use divergence to initiate a short trade...But I often see Reversing divergence
 developing when in a long position and may use it as a rational to close the trade.



Bearing the above caveats in mind:

A nice example showing a short entry that became available at the trend line break :

While price printed another HH, "Reversing divergence" had developed on the indicators.

  
Below are different interval charts of the same action as that seen on the 180 tick chart above.
On the LH side a 2 minute, in the center the 180 tick and a 90 tick on the right.
The lines were first drawn on the 180 tick chart and then transferred to the 90T for perspective. 
 These examples show how Two Indicator Reversing Divergence is apparent on all three charts.
(click on charts to enlarge)

Another example of a short trade using PA and indicator signals that are showing Reversing divergence...


A reminder...it has been my experience that
Using divergences as signals at tops is not as powerful 
and are less reliable than those that occur at bottoms.

Flip-flop Divergence


Recognize Reverse Divergence and be ready for Regular Divergence to follow. Price action was making HH's and HL's (trending up) while the MACD histogram was indicating a very strong LL trough...(indicating that the move down was over-done)

NOTE: Price did oscillate up and down a bit after the last HH that is marked on the chart. It made a minor LH after that point but did not make a new major LH when you consider what was happening in the overall trend...the last major HL turned out to be at the circled area where price resumed its upward movement. 

As I indicated above, PRICE ACTION can be subjective; open to interpretation or to revision as more data and price-bars print on the chart...

 Also recognize that Reverse Divergence can follow Regular Divergence. Price action on the chart below was showing a HL while the MACD histogram made an 'exaggerated' LL, indicating the down move was over done...the Stochastic was very oversold too.

3/11/2013 3xD divergence FAILED...or did it?

3xD can and does fail to precede directional changes

...and sometimes it can depend on the Target and Stop levels you use...


8/21/2013 ALWAYS Protect Your EQUITY
Even when there are "great" divergence signals, price may not change
to the new direction you have...anticipated...
Stop loss orders can help protect against divergence signals that 
fail to produce the reversal you have...expected...


It is very easy to get caught up in an adrenaline rush when trading multiple times a day.

You must stay aware of this at all times to avoid over-trading and making poor trades.

You have to continually ask yourself the questions...
Do you trade for excitement or to take money from the market?
Do you feel lucky....Well, do you .........? 


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DISCRETIONARY TRADING...INDICATOR SET UP