Gap, Flag, and Divergence: A Day that Had it All

Nov 10, 2008: 7:37 PM CST

I know that today’s trading was frustrating for many reasons, but by the end of the day, we’d developed a successful gap-fade trade, a couple of bear flags, and a couple of positive momentum divergences – all of which are worth reviewing for educational purproses to build pattern recognition skills for the future.

DIA 5-min chart:

The day started with an overnight gap of roughly $2.00 in the DIA, which usually does not result in a successful fade trade, but today was the exception thanks to the rampant volatility that still remains in the marketplace.  Price quickly moved down to fill the upside gap with only a minimal retracement before hitting its target (yesterday’s close) and finding support there about the 50 period EMA.

Price attempted a rally – which would be a good place to buy – but the rally was unexpectedly short-lived and found resistance via the falling 20 period EMA.  At this point, a new price and momentum low were established as support was broken, hinting that lower prices were yet to come.

By Noon, the key moving averages crossed over as price mounted a ‘flag’ style 45 degree angle retracement up to confluence resistance, which held as price completed (and exceeded) a measured move down to further new price and momentum lows on the day.

Finally, at 1:00, price mounted a swift though quite choppy counter-trend move up that penetrated both the 20 and 50 period EMAs, likely taking out any stops the short-sellers were trailing… just before moving swiftly lower into the 3:00 hour.  Price actually set-up a bear flag, though generally I like to place stops just beyond the 50 period EMA which – in this case – were taken out.  I like for flag set-ups to retrace no more than 50% of the prior impulse and find resistance (or support) at key moving averages.

Those with strong stomachs survived the ‘rinse,’ while those like me who tend to prefer tighter stops (though we know we shouldn’t) were washed.  I’ve since learned to re-enter trades that ‘nip’ away my stop-losses and develop the courage to do this over time and multiple experiences.  It takes practice.

Anyway, as price trended to new lows on the day, the momentum oscillator failed to confirm these lows, setting up a positive momentum divergence that hinted at bearish weakness and the potential for short-term bullish strength.  Bulls finished the day strong (relative to their previous performance on the day) and pushed price above the key moving averages and away from the day’s lows.

It was a semi-confusing day in practice, though a much clearer picture has emerged now that the price action has completed.  The day serves as a great example of how a gap-fade, bear flag, and positive divergence interact to create possibile trades in the larger price structure.

5 Comments

5 Responses to “Gap, Flag, and Divergence: A Day that Had it All”

  1. Dominick Says:

    Hello Corey, another very educational analysis as always, Thanks. Two questions. Are you getting any insight into the price movement from the light blue histogram part of the 3/10 oscillatior or are you mostly going off of the black EMA line? Second, when you are counting your price swing lows/highs such as the ones from the prior Goldman analysis, do you ususally use the closing/opening price of the candlestick or the highest/lowest price off the shadows?

  2. Corey Rosenbloom Says:

    Dominick, Thank you for your questions.

    No, I don’t draw any significance from the MACD histograms. The way the ‘pure’ 3/10 Oscillator is drawn, there are no histograms, and it actually uses simple MAs instead of Exponentials, but I place no emphasis on the histogram, which is simply shows the crossovers in the MACD and the signal line. I draw no significance off those crossovers.

    In regards to swing highs/lows, I prefer to use closing prices as that indicates overnight conviction and adds a little more weight, plus the 3/10 Oscillator only takes into account closing prices (as they are based on EMAs) so it’s helpful to compare apples to apples, but occasionally – if it provides insight – I’ll consider candle wicks, provided they’re not errant ticks. But the emphasis should be on the closes.

  3. Tom Says:

    Corey do you ever trade the DXD or any of the other inverse or ProFund double ETFs, TWM being another example for the Russell 2000. I find them to be a good vehicle particularly for fade the gap trades.

  4. Corey Rosenbloom Says:

    Tom,

    No, mainly I stay with the Dow-Mini futures for intraday trading and standard ETFs for sector rotation position/swing trades. It’s quite rare that I’ll swing trade with individual stocks or leveraged ETFs. I’ve tried so much that I just stick with what I’m comfortable with now, but I’ll keep that in mind. Good insight!

  5. Dominick Says:

    Corey, thanks for the response and the insight. It is always helpful and appreciated.