Momentum Divergence Example

Oct 18, 2007: 10:27 AM CST

The momentum divergence concept can help you exit a trade near the expected peak in price, or it can help you enter a position with a relatively high probability of success.

Recall that the price action moves in waves, as the overall supply/demand imbalance in a trend shifts from buying, to profit taking, to more buying, to more profit taking with new short positions, etc.

We can use various momentum indicators to measure the length of the relative swings to each other, in an attempt to visualize increasing or decreasing pressure on the side of the more dominant market force (buyers/sellers).

We compare price highs and price lows to customized oscillator highs and lows. We want to see confirmation in the indicator with the price structure, but non-confirmations warn of price divergences.

Let’s look at a recent picture-perfect example:

DIA on October 15th (5-minute)

There are actually two forms (trendlines) of divergence occurring here. There are the shorter term swings and the longer term structure.

As price is making new lows on the day, momentum is making higher lows on the day, meaning sellers are losing ‘momentum’ in pushing price lower. We should be expecting a bullish/buying resolution to take us to the price where the divergence was first observed.

There are four new price lows in the DIA, and four higher price lows in the oscillator. Eventually, buyers resolved the divergence with a strong move into the close towards the upside.

Let’s look at the same move from a chart in TradeStation:

When you see a momentum divergence, especially a lengthy one, you can use it to exit your position at a new price low (with non-confirmation from an oscillator), or you can be aggressive and establish a speculative position that the opposing force will prevail.

Because this is a countertrend trade by nature, it is best to use absolute stops if you are speculating against the trend.

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