Finding Hidden Setups Using Advanced Divergence Strategies

Trading divergences has been a cornerstone of my trading for some time. I just love to find setups where the stock might be saying one thing while either the market or the stock’s technicals is saying something else. It kind of reminds me of a politician during election time.  

I like to look for two types of divergences:

1. Stocks that diverge from broad-based market or sector indices
2. Stocks that diverge from price oscillators

For the first type of divergences, I look for stocks that are weaker or stronger than the general market and/or their respective sector indices. The strongest stocks are the ones that go up while the market is going down. In this case, the stock is said to have a positive divergence with the market. For example, if a stock can buck a downtrend and move higher in a market like this, something must be very special. Obviously, the “smart money” is accumulating the stock because something good is going on with the company. Therefore, you would definitely want to keep that one on your radar as a long candidate.

On the other hand, the weakest ones are the ones that go down while the market is moving up. In other words, the stock has a negative divergence with the market. Conversely, when the general market is moving higher and higher, but a stock is not following or is moving lower, the “smart money” is distributing the stock. That stock could be a good short candidate.

Here’s how you can search for these types of divergences:

• One way to look for these stocks is to use some type of charting software such as TC2000, Metastock or Supercharts. Plot the stock on top and an index or sector index on the bottom. Sift through the charts in your database. On days the market is down, pay special attention to the stocks that are bucking the trend and are moving up. These are the strongest stocks, and these are most likely to continue to move higher. Yes, going through hundreds and perhaps thousands of stocks can be a long and tedious process. However, there’s a good chance that you’ll uncover some gems that have been overlooked by the financial media. The stocks that are consistently bucking the trend are the strongest (weakest for shorts), and they are the ones that you should be trading.  
  
• Another way is to look at the top gainers or losers list. On a day where the market is down, look at the top gainers list. On the other hand, when the market is up, look at the top losers list. If the stock is consistently on the top gainers list while the market is down, pay attention to that one. And if a stock is consistently on the point losers' side while the market is up, you may want it on your short list.

Generally, I prefer the first way because it lets me see the divergence visually. I can see how much the stock outperforms or under-performs the market. I also like to draw trendlines on both the stock chart and index chart. Since I consider myself a swing to intermediate-term trader, I would like to see a stock diverge for at least three to five days. And preferably, the stock has taken out some important resistance. I seldom base a trade solely off a divergence. Rather, the divergence is used as a “heads up."  

Let’s look at a couple of examples:

For the second type of divergence, I like to look for stocks that have made a new swing high or swing low. I would then look at certain price oscillators to check and see if their moves are confirmed by the price oscillators. If they are not, this tells me that the moves are unsustainable and some type of a pullback or reversal will likely occur.

The oscillators I use are:

• Momentum – momentum is really a rate-of-change indicator. It compares the stock’s current close to the close of some number of days ago. As long as a stock closes higher and higher and by a greater amount each day, the momentum is increasing. However, as that rate of change starts to slow, momentum decreases and a pullback or reversal is likely to follow. Think of launching a model rocket. The start of the launch has the most momentum as the rocket gets off the ground. As the rocket goes higher and higher, at some point it will run out of momentum and head back down. It’s kind of the same for a stock.  
  
• RSI – The RSI, or Relative Strength Index, is a price oscillator that compares the stock’s up closes to down closes over a number of days. Typically, it’s used to identify overbought and oversold levels, but I prefer to use it to spot divergences.

For instance, when a stock makes a run to the upside and makes a short-term high, I like to use conventional technical indicators such as the RSI and momentum oscillators to tell me if they agree or disagree about the move. For these indicators, pay special attention to:

• A stock that rises, but the momentum or RSI is falling (Negative Divergence)
• A stock that falls, but the momentum or RSI is rising (Positive Divergence)

Typically, I would like to see a divergence in both indicators, as that adds more weight to the evidence. However, sometimes one is enough. So how do you know which divergences to trade? Well, first, to help you see the divergence, you need to draw some trendlines. Draw trendlines on:

• Prices – Draw trendlines connecting the prior high to the new high or prior low to new low
• Momentum Indicator - Draw trendlines connecting the prior high to the new high or prior low to new low
• RSI - Draw trendlines connecting the prior high to the new high or prior low to new low

The most important thing to look at is the size of the divergence as measured by the steepness of the trendlines. The steeper the angles of the trendlines, the greater the divergence between price and the oscillator. Let’s look a few examples:

In conclusion, adding divergence analysis to your arsenal can help you:

1. Spot the strongest or weakest stocks in the market.

2. Identify potential pullbacks or reversals.

For The Best Trading Books, Video Courses and Software To Improve Your Trading Click Here