Inside a Momentum Divergence

Apr 21, 2008: 12:01 PM CST

I use momentum divergences as a large part of my trading, and I thought I’d take you inside a momentum divergence so you could understand the concept better.

First, let’s start with a definition.

Price can be defined as the aggregate value of all participants in a market as they express their hopes, desires, fears, and other considerations as they establish positions (whether as hedged positions or outright directional positions).

Momentum can be defined as the speed or force of prices traveling in a given direction.

Thus, price may be moving higher, but doing so at decreased speed or decreased force (or urgency). If this situation develops, we would consider this to be a ‘momentum divergence,’ in that momentum is registering an opposite reading to price direction.

One may also think of it as throwing a ball into the air. As the ball reaches the apex (the highest point), the ball slows down its speed accordingly before stopping and then reversing… slowly traveling down at first but then gathering speed as it heads closer to the ground.

In this example, I am showing a positive momentum divergence via Harley Davidson (HOG) at the beginning of 2007. Notice that price is trending lower, and we can see this through a series of lower lows and lower highs. It’s best to view momentum divergences in comparison with swing highs and swing lows in price, combined with the overall direction.

Notice on March 12th how price makes a lower low on a pronounced and strong price swing down, which registers in our momentum oscillators as making a lower low as well. For this example, I’m demonstrating the 3/10 Oscillator, ROC (Rate of Change), and MACD Histogram.

A counterswing up occurs until around March 19th, and then a new downward impulse occurs. However, this particular downward impulse – although it took prices lower – failed to do so with the strength (or magnitude or length) of the previous price swing.

I drew two hashed lines to show the length of the downward price swing and how it set-up the classic divergence. With price making a lower low, but doing so on less speed or force than the prior price low, a positive momentum divergence forms, which is picked up by our oscillators.

Each of the oscillators (and there are more we could use) makes a higher low while price makes a lower swing low. This warns us that the sellers are losing force (or ‘power,’ conviction, momentum, etc) and that a reversal in price may be setting up. If anything, divergences warn us to take profits if we have them in a position.

It is important to note that divergences alone do not signify trend reversals – they merely indicate a weakening posture of the dominant force (be it buyers or sellers) and that the next counterswing could be stronger than prior counterswings. Sometimes divergences do indeed precede trend reversals, but it’s best to use them as warning signs and allow price to complete a reversal before repositioning.

I’ll be discussing how to use divergences in more detail in future posts. Be sure to check back for more information.

 

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