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martes, 23 de diciembre de 2014

How to trade a price-indicador divergence?

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A divergence between prices and an indicator occurs when both go in the opposite direction: prices rise and the indicator falls; or prices fall and the indicator rises.

The divergence may continue for a long time and no trader wants to buy (or sell if we go short) too early.

The key is to use a trigger to get a confirmation of the trade we intend to do.

The following figure shows two divergences, the first is a bullish divergence and the second is a bearish divergence.


Here are the rules for bullish divergence:

  • Use Momentum indicator of 28 periods (any other momentum indicator can be used as the RSI).
  • Notice the last 60 bars (in the chart below the red vertical line indicates the limit)
  • Find the lowest price on the 60 bars and mark it with A.
  • If the price momentum corresponding to A is not the lowest, then we have a bullish divergence.
  • If we have a bullish divergence, mark the momentum with B.
  • Step back in time and mark the lowest momentum with C and the price with D.
  • Between B and C must be at least 6 bars: now we have the setup.
  • We seek the highest momentum between C and B and mark this point with E
  • The trigger is when momentum exceeds E. Another way is when prices exceed the downward diagonal resistance (blue line).

And now the rules for the bearish divergence (are the same but inverted)

  • Look for the highest price in the 60 bars and mark it with A.
  • If the price momentum corresponding to A is not the highest, then we have a bearish divergence.
  • If we have a bearish divergence, mark the momentum with B.
  • Step back in time and mark the highest momentum with C and the price with D.
  • Between B and C must be at least 6 bars: now we have the setup.
  • We find the lowest momentum between C and B and mark this point with E.
  • The trigger is when momentum exceeds E.
In the figure below, when prices break the support (blue line), the momentum should confirm by falling below the red line.






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