How To Trade Divergences
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What is a divergence?
A divergence is basically where you have the market going one direction and you have a technical indicator going the other, where normally they move in sync with each other. For example we have a simple chart here Zoom and with Zoom we have candlesticks for the market itself, and then we have an RSI just a simple RSI on the chart below, and with this RSI you can see if it's above the upper green line, it turns red meaning it's overbought, and if it trades down below the lower green line it turns blue meaning it's oversold, and we see a situation here with Zoom where the market is going up and making new highs and RSI is making new highs. Then zoom backs off, and then Zoom goes back and retest the highs and as it retests the highs the RSI gets nowhere near its old highs. You can see it's actually now starting to create a downtrend.
The way divergences work is they basically help us see the forest for the trees.
They give us the mechanical view of what's actually going on inside the market, and there's lots of different divergences. There are divergences with indicators like this. There are internal divergences, which we'll be discussing in a later session with things like advanced decline, that sort of thing. We can see here. As we retest the highs, there's a divergence in RSI. This gives the potential possibility of selling and retest the highs, because of the divergence, knowing that now the market is weak, and sure enough, it sells off. We talk a lot about a hierarchy of indicators, and most technical indicators are lagging, they're late, and oscillators used for divergences like this are also usually late.
Why use them?
We use them because they give you a picture of what's going on inside the market. They help frame the market environment. If we see a market making new highs, but the indicators not making new highs that tells you the environment is weakening, and that's how we would play this. Now, here's another example and Zoom now we're making new lows, and RSI is making new lows. It's oversold, and the market backs off and the market pushes to new lows, but RSI never gets back to oversold. In fact, it's divergent. Now we would be looking to set up, looking at the price action looking for a place to potentially get long for the market to rally. Now that all sounds great, but we actually have to talk about how to trade divergences.
I've mentioned how we use them, but we actually have to learn how to trade them.
Let me share a story with you. I hired a really brilliant technician to come in and work for me my old trading firm and he worked for Paul Tudor Jones. I brought him in, and he was teaching me some of his techniques and how he reads the market and reads charts. I had a big position on in the Chicago Mercantile Exchange and CME, and I was was long and looking to short it looking to liquidate my lungs and potentially go short because if I was overbought. He shared with me, he taught me how it was divergent, similar to what we saw on this chart. CMEs continue to make new highs and indicators continue to make new lows and the divergence got bigger and bigger. Here's the problem with divergences. Just because you get a divergence does not mean the markets gonna roll over, and sell off. In fact, it can keep going higher and the divergences can keep getting bigger, and that's actually what happened. You can actually go broke, you can lose a lot of money, trading divergences because you're short and the market is going higher, and the indicators or oscillators keep saying the market is getting weakening. Well, in your mind, you're thinking, "Well, I'm not wrong. Why would I cover now if the divergence is getting bigger and bigger?" but at some point, you just can't sit in something forever just keep losing money. That's the problem.
How do we resolve this?
Well, if we go back to the hierarchy of indicators volume, which is one of our leading indicators, it's one of the only two, we look to volume to show us how to trade divergences. If I'm in a situation, let's say like this one, where the markets making new lows, but we're getting divergences, so the market is strengthening even though we're making new lows. I will be in here looking at the volume flows, and if I started to see volume trap or I started to see volume wane, then I would get long, but not until then, because volume can drive right through divergence. There could be a divergence in your indicator, and the market does not care.
If the Fed decides they're going to do something you think they care about the markets divergent? Do you think they care your indicators are divergent? Hell, no, they don't. We look at volume flows. The divergence helps set the environment and the volume flows tell us when it's time to get in. If volume just keeps pushing down, we're not going to buy, we're going to wait, but eventually volume will lose its power, and it will dissipate or to trap and then we can get long off the divergence.
That will be enormously helpful for you. This is a technique we go into in detail in our courses, where we use our own private indicators. Think about how you trade divergences and how what I shared with you today might be helpful. I hope you have an amazing week. Please continue to like these YouTube videos. I appreciate that, and we have our WAM Dividend Accelerator, this is a method on trading dividend stocks, it's unlike anything in the world, we have our WAM Dividend Accelerator Masterclass starting this week. If you're looking for a way to create consistent income in your portfolio, this is the way to do it. Check that out. Have a great week. I'll see you next Tuesday. Bye.