Tuesday, March 09, 2010

Divergence Analysis (Guest Post)

Brandt of Trade-Guild.net
I once read that, "to make money in Technical Analysis is to see something the crowd missed." With the advent of online trading and Technical Analysis going from vodoo-science to mainstream, conventional analysis as you'll find in any number of a thousand books is not only not giving you an edge, in many cases, it is causing you to herd like a sheep into a market's traps. In some ways, especially for shorter term traders, Technical Analysis has become an albatross. However, the proponents of T.A. will  rebuke your failures as not having had sufficient discipline.
I've tested many systems found in popular books and found they perform WORSE then buy and hold, but the author only shows you the trades that make their system look like the next Holy Grail. Speaking of Holy Grails, there aren't any-Money/Risk Management is the closest you'll get.
This does not mean you can't be successful using Technical Analysis, you just need to stray from the flock. Over the years I've written many custom indicators, in doing so I know that I'm seeing something that no one else in the world is seeing. I've also found that using conventional indicators in unconventional ways is also helpful. As a trend trader (most of the time), my typical MACD Histogram settings are 52/104/3. My Stochastic settings are usually 100 period, thus I filter out a lot of noise and expose the trend.
Divergence Analysis
photo by Jenny Downing
The best use of nearly any indicator is Divergence Analysis. I find in teaching my classes (beginners and intermediate TA) this is one of the hardest concepts for people to understand. For example, oscillators that people use for oversold and overbought signals I find (for myself) to be nearly useless, but using them to look for divergences makes even the most mundane indicator such as ROC, quite useful.
As far as custom indicators, I've developed my MACD Heat Map for entering, holding and selling a trade; my Trend Channel for catching trends in any timeframe and having an objective stop out point that locks in gains everyday. I created an indicator based on Price/Volume relationships and it forms a cumulative line that exposes divergences. I have a screen with a custom indicator used for moving average cross-over systems to avoid whip-saws and false signals and several others as well.
The basis of most of my trading is centered around my proprietary indicators I call 3C and their cousin 4C. While these indicators do have a numerical value, it's useless to me; I use them for one thing only-seeking confirmation, positive and negative divergences. By using multiple construction of the (3) 3C indicators and multiple timeframes, I can get a fairly reliable view of distribution and accumulation and through the different timeframes I can usually come very close to pinpointing a reversal in the market.
Daily 3C signals are the broadest (or multiple days) and give you a strong sense of confirmation of a trend or distribution/accumulation. It's impossible to know how many shares and how many institutions are distributing and thus when distribution will end and a reversal will take hold. That is why I first use all 3 versions of 3C-some are faster then others and first get confirmation that I am seeing distribution which typically happens as price rallies. Then I use multiple intraday time periods to better pinpoint the end of distribution and find the reversal day. When all 3 indicators line up in multiple timeframes with the same divergence, I know we are close. During Q2 2008 I was able to use 3C to predict the reversal of a nearly 6-year rally in oil down to about a week.
Top of the Bull Market in oil
Here's a 3C 4-day chart of the QQQQ (I find that ETF's give faster and more reliable signals then do the underlying average they represent). You can see distribution occurring in early 2007, using consecutively shorter term charts it is possible to more accurately predict the reversal. Note the positive divergence at the March lows and the recent negative divergence into 2010.
A daily 3C chart of GS shows distribution which can include short-selling into the Head and Shoulders top. The indicator is now in the most serious of divergences, a leading divergence.
Here's another version of 3C (remember I use 3 that are each written differently) applied to a 15-minute chart of  QQQQ. You can see the positive divergence that kicked off a bounce around 2/25 and the distribution starting around 2/2. The indicator actually hits the highs of the day and has continued into a leading negative divergence.
These are a few ways I try to "see something the crowd missed." Most of my indicators can only be reproduced in TeleChart or StockFinder as I use some of their proprietary indicators as a starting point for my own. However the concepts can be applied to many different indicators if you have the ability to write custom indicators with your stock charting platform. The main point I hope you take away from this article is to venture off the beaten path, experiment, a lot can be found in subtlety and look for that which the crowd missed.
About the author: Brandt is the publisher of Trade-Guild.net  and Wolf on Wall Street with over 1300 posts and over 200 videos on YouTube. He teaches beginners and intermediate Technical Analysis for an Adult Education program in his county's school district as well as privately. Brandt has traded using Technical Analysis over 11 years including trading professionally. His indicators, trading systems and risk management concepts have received several awards as well as having been published.
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