Two Roads Diverged: Trading Divergences
Dr. Alexander Elder
Copyright 2012 by Dr. Alexander Elder
Published at Smashwords
ISBN: 978-1-4524-7698-8
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.
Robert Frost (1874 – 1963)
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Disclaimer of warranty: while the author has used his best efforts in preparing this book, he makes no representations or warranties in respect to the accuracy or completeness of the contents. The advice and strategies contained herein may not be appropriate for your situation. You should consult with a professional where appropriate. The author shall not be responsible for any loss.
Last revised: January 2012
Books by Dr. Alexander Elder
Trading for a Living
Study Guide for Trading for a Living
Rubles to Dollars
Come into My Trading Room
Study Guide for Come into My Trading Room
Straying from the Flock
Entries & Exits: Visits to 16 Trading Rooms
Study Guide for Entries & Exits
The New Sell & Sell Short (with Study Guide)
To Trade or Not to Trade: A Beginner’s Guide (e-book)
Table of Contents
A Bullish Divergence: A Basic Definition
What is NOT a Bullish Divergence
A Bearish Divergence: A Basic Definition
What is NOT a Bearish Divergence
Entries, Stops, and Profit Targets
Additional Points on Divergences
Divergences in Other Indicators
Divergences in Multiple Timeframes
The Next Step: MACD Semi-Automatic
To find the truth, look below the surface!
What you see on the surface is often deceptive – in trading, as well as in life. A trend may appear strong, while below the surface it may be weak and ready to reverse.
We have indicators that measure the internal power of a trend. At times they confirm an uptrend and tell you it’s OK to hold or add to your positions. At other times they signal that the trend is suspect: it is better to exit, take profits, and even consider switching from long to short or vice versa.
A divergence is a disagreement between the patterns of indicators and prices. We find bullish divergences near market bottoms and bearish divergences near market tops. Many traders use these words very loosely – I want to make these important terms very clear. The purpose of this book is to help you ride price trends with greater confidence and recognize upcoming reversals before they hit the crowd.
Needless to say, I hold no monopoly on wisdom. I’ve learned my craft from those who went before me and still consider myself a student in the graduate school of hard knocks. If you think you see an error in this book, please write to me and let me know.
How to Work with This Book
We’ll begin by reviewing basic definitions and then look at many examples. I’ll invite you to take several reader exercises. We’ll review divergences in different indicators. We’ll explore divergences in different timeframes – from investing to day-trading.
Keeping good records is the keystone of successful trading. Please stop for a moment before you do any exercises in this book. Open your word processor and create a file “Working with divergences.” Write down the number and the name of each exercise and your reasons for answering Yes or No. By the time you get to the end of this e-book you will have a nice learning file. It will help you master the topic and trade divergences with greater confidence.
An important reminder: successful trading is based on three M’s: Mind, Method, and Money (psychology, tactics, and risk management.) All three are essential for your success. This book focuses on only one M – Method. You may use this book as a guide to market analysis and tactics, but remember to implement the other two Ms, discussed in my previous books, into every trading decision.
Free Updates & the Honor Code
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And now, let’s embark on our journey.
Dr. Alexander Elder
New York City
January 2012
Review of Tools
To profit from divergences you must have a basic understanding of technical analysis. There are many sources, including John Murphy’s magisterial Technical Analysis of Financial Markets as well as my own Trading for a Living.
Here we will glance at few key definitions, but if anything is unclear, please refer to the above books.
PRICE, MOVING AVERAGE, SUPPORT & RESISTANCE
Each price is a momentary consensus of value among the mass of market participants.
Since each price is a snapshot of current consensus, a moving average is a composite photograph, reflecting an average consensus of value during its time window. A rising moving average shows that the market is optimistic – bullish; a falling moving average shows that the market is pessimistic – bearish.
We draw support and resistance lines across the edges of congestion zones. The extreme highs and lows reflect only the panic among the weakest market participants, while the edges of congestion zones show where the mass of traders changed direction.
I use bar charts because I learned to trade using them. I have nothing against candlesticks, which came later; all examples in this book could have been rendered using candles.
MACD
Moving Average Convergence-Divergence (MACD), invented by Gerald Appel, is a popular market indicator. It combines trend-following features (MACD Lines) with those of an oscillator (MACD-Histogram). MACD-Histogram tracks the difference between MACD Lines. Warning: some software packages plot this indicator incorrectly. For example, Metastock instead of plotting the difference between the lines as a histogram, simply plots one of the lines as a histogram. For years I have been telling the folks at Metastock that their plot is incorrect – to no avail. In the interest of accuracy, our elder-disk for Metastock contains a correct plot.
In this book I’ll use standard MACD values of 12-26-9, but I encourage you to experiment with these numbers, making each of them slightly larger or smaller. It is a good idea to use indicator settings as individual as you are. There are no magic numbers – only the numbers you’ve tested and come to trust.
We will look at a few examples of divergences using other indicators. Please feel free to apply the concepts of this book to other indicators you like.
TIME
Remember that markets move in multiple timeframes simultaneously. We all have our preferred periods, for example the daily or a 5-minute chart, but one timeframe is not enough.
The Triple Screen trading system requires you to begin your analysis by examining the timeframe one order of magnitude longer than the one you like to trade. If your favorite is the daily chart, begin by looking at the weeklies. Make your strategic decision there to be a bull or a bear and then return to the daily chart to make tactical decisions on entries and exits.
Chart parameters in this book:
Weekly: 26- and 13-week exponential moving averages (EMAs).
Daily: 22- and 13-day EMAs, some include Autoenvelopes centered around the slower EMA.
Intraday: same as above, only 22-bar and 13-bar EMAs.
MACD is 12-26-9 on all charts.
A Bullish Divergence: a Basic Definition
In the first chart I will show you my favorite example of a bullish divergence. It has two great features: first, it is technically flawless, and second, it was hugely timely. It gave a major buy signal within a week of the historic 2009 bear market bottom, auguring in a new bull market. Not all patterns are this perfect, and we will deal with more difficult cases later in this book. Remember this rule: when trying to find a divergence, first look at the pattern of an indicator and later at the pattern of prices.
Trading for a Living offers this definition: “A bullish divergence occurs when prices trace a bottom, rally, and then sink to a new low. At the same time, MACD-Histogram traces a different pattern. When it rallies from its first bottom, that rally lifts it above the zero line, ‘breaking the back of the bear.’ When prices sink to a new low, MACD-Histogram declines to a more shallow bottom. At that point, prices are lower, but the bottom of MACD-Histogram is higher, showing that bears are weaker and the downtrend is ready for a reversal. MACD-Histogram gives a buy signal when it ticks up from its second bottom.”