Lesson in Divergences Plus Trendline Breaks in Dollar March 31

Mar 31, 2011: 5:50 PM CST

It seems all traders seek to answer the same question:  “When is this market likely to reverse?”

Newer traders tend to love “reversal” style strategies, wanting to enter as close as possible to a trend reversal in order to have the tightest stop and biggest target possible.

While no strategy can call a top or bottom all the time, one of the best ones I’ve found is to look for multi-swing divergences followed by a trendline break as a high probability, low-risk trigger for entry into a potential major shift in a market trend.

Let’s take a quick look at this concept as played out in the US Dollar Index (really it could be anything) through March:

Click for full-size image.

As you probably know, I am a huge fan of trading divergences and have posted dozens if not hundreds of times on the topic of trading divergences in multiple markets.

Here is a quick sampling of some of the recent educational posts:

“A Lesson in Trading Dual Divergences on Two Timeframes in Dollar UUP”

“A Lesson in Playing Intraday SPY Reversals with Dual Divergences”

“When Divergences Really Matter:  SP500 at 1,300”

“Lessons from Crude Oil Divergences and Head and Shoulders”

“Divergences and Breakout Lessons in Goldman Sachs in 2010”

“A Quick Lesson in Intraday Divergences in SPY December 16 2010”

“Lessons from Crude Oil in Dual Divergences, Kick-offs, and Breakouts”

Take a moment to look over some of those for background reading.

The main idea with the Divergence plus Trendline Break situation is that the Divergence (in momentum using the 3/10 Oscillator) is your first warning signal of potential trend reversal – and the more “swings” build up a divergence (when price continues to push higher while the oscillator continues to slip lower on each swing) – then the greater the odds of a reversal.

You can’t necessarily trade BECAUSE there are divergences – you need a TRIGGER.

The best trigger/signal comes from price breaking through an opposing trendline that connects the rising (or falling) trend.

So if you observe a multiple swing divergence then see price breakthrough a corresponding trendline, THEN that is a much safer signal that odds are strongly likely to lead to a reversal in the timeframe trend.

Of course, nothing guarantees a reversal so you’ll need to place your stop beyond the absolute swing high or low in the event the market trend pushes on beyond what you think it can – this higher risk is inherent (cannot be removed) from aggressive-style reversal trading strategies.

In the chart above, we have three such trend reversals in structure (series of price highs and lows) in the Dollar Index:

A)  March 11th gave us a multi-swing negative momentum divergence that was followed with a signal via a trendline break at the $76.80 level.

In this case, price fell sharply from the high and broke an otherwise ‘lazy’ trendline that couldn’t keep up with the recent swing high – leaving this trade to be a later entry than perhaps was comfortable.  It did produce a trend reversal as expected though.

B)  This was a big one, and given the bearishness on the US Dollar index, it may have been a difficult trade to take but it was effective.

The Trend Structure continued pressing lower (lower lows and lower highs) though the momentum oscillator continued building a positive divergence situation which eventually gave-way on a breakthrough of the falling (tighter) trendline on March 22nd at the $74.50 area – allowing for a tighter stop under $75.30.

Price continued its pulse higher and then recently slammed into a triple top formation – with its own divergences – at the $76.40 level… leading to the recent trendline breakdown and opportunity.

C)  The triple-top served as a clean resistance area which had its own negative momentum divergence and trendline breakdown on March 30th which sent the index moving lower into the present session.

Without going into exhaustive detail, I wanted to highlight this lesson/concept – discussed in far more detail in Chapter 2 on “Momentum’s Leading Edge” in the new Complete Trading Course book.

The Dollar Index served well in describing this concept of Divergence plus Trendline Break equals likely structural change – and the inherent trading opportunities that come from changes or reversals in market structure.

Corey Rosenbloom, CMT
Afraid to Trade.com

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Corey’s new book The Complete Trading Course (Wiley Finance) is now available!

2 Comments

2 Responses to “Lesson in Divergences Plus Trendline Breaks in Dollar March 31”

  1. JeffreyLin Says:

    thx. great comparison of the 3 $DX_F reversals. Like that u kept it on the same product/chart so we can see the continuation and behavior shift of the dollar.

    I'd add that key for swing is continuously watching price action several bars after the signal, low/high, or price break. If you really are that early in the swing, don't want to take profits too soon. Maybe even add when that confirmation is set.

  2. Corey Rosenbloom, CMT Says:

    Thanks Jeffrey!

    True, I didn't get into exits/profit taking but one could hold aggressively until the next divergence/trendline break, particularly on these lower timeframes.

    And as always when working with trendlines, traders can use different entry strategies such as two-bar closes outside the trendline or a certain ATR multiple outside the trendline. Or of course just keep it simple and go with the trendline break itself on a bar close.

    This concept can be layered with any other strategies a trader is using.