DJ Utilities: A Lesson in Momentum Divergences

Jun 1, 2007: 1:35 AM CST

I wanted to point out the recent action in the Dow Jones Utilities Index – it is a lesson on how momentum divergences play out.

First, the chart:

dow-utilities-may-31.png

I have not annotated this chart (with trendlines) to show the divergences – note both oscillators making lower swing highs while price makes increasingly higher highs.

Divergences in momentum tend to correct down to where the momentum divergence (on the 3/10 Oscillator – bottom pane) first was observed.  Even the trusty stochastic indicator made clearly visible divergent patterns.

It is a known theorem from the Fathers of Technical Analysis to Linda Raschke and others today: Momentum Precedes Price.

This occurs both in the form of momentum highs leading to new price highs (indicated also on this chart with a new price and momentum high on March 26th) and the form of divergences, which are nothing more than a coming balance of buyers and sellers (and a reversion to the mean type of price behavior). This is evident with the ‘snap’ decline and rolling upper peaks in price throughout the month of May.

Now, we are observing new momentum lows and a potential “Impulse Sell” style trade where momentum makes a new low, corrects back upwards, and then makes new price lows. This could happen with a failure test of the (now) declining 20 period moving average.

Study your charts in terms of momentum readings and indicators. They are not the ‘magic bullet’ of course, but they can alert you to some greater than normal probabilities of potential upcoming price movement.

Of note, we are seeing clear momentum divergences just like this in the major indexes. I recommend caution, but I do not attempting to short this market yet.

4 Comments

4 Responses to “DJ Utilities: A Lesson in Momentum Divergences”

  1. Joe Says:

    Corey,

    Maybe it’s just bad timing 😉

    When you bring up the momentum divergencies, it looks like the markets are just adding one more divergency after another, and yet still move up and up and up. How can you avoid to fight the trend and profit from divergencies?
    Thanks ,Joerg

  2. Corey Says:

    Althought momentum divergences alert us to possibilities of price movement, the resolution of these divergences often occurs suddenly and violently as traders get trapped or initiate alternate positions – thus it is difficult to profit from divergences as readily as it is new momentum highs.

    Momentum divergences put is squarely in conflict with another major market axiom, which is that Trends have Greater Odds of Continuation than Reversing. It is difficult to fight a trend, and some trends show greatest strength at their climax or conclusion.

    Momentum divergences are natural patterns that emerge when (in this case) buying pressure is slowing relative to the past. The implication is that the end of the prior price motion will slow when buyers are satisfied (or there are no more buyers) and ‘bag-holders’ are forced to sell… as well as savvy traders seek to profit from this unfolding by (as you highlight) initiating new short positions, further fueling the decline.

    Another thing, momentum divergences simply highlight conditions, and don’t necessarily provide objective buy/sell levels unless you are an aggressive trader. You’ll almost have to take some price heat until your theorem (price will correct) is proven true (if at all).

    Typically, a momentum divergence trade is good for a small target with a tight stop, but sometimes you get lucky and take home more in a divergence trade than you expected, which is always nice. But you’re right, it’s difficult psychologically to fight an established trend.

    Thanks for the comment!

  3. NASDAQ TICK and Other Market Insights for a Friday | Forex Hour to Hour - Forex Trading News, Forex System Reviews, Twitter Updates Says:

    […] * Utilities Off Their Highs – Rising rates taking their toll; the Afraid to Trade Blog passes along a relevant lesson regarding momentum and price. […]

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