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Stocks & Commodities V.15:12 (568-571): Reverse Divergences and Momentum by Martin J. Pring

INDICATORS

Reverse Divergences And Momentum

An oscillators failure to confirm the higher high or the lower low of the market is a red flag to most technical traders. Is there a message when the price diverges from the indicator? This veteran technician thinks there is. by Martin J. Pring echnical analysts are constantly comparing prices and indicators to see whether they
C A C B

Normal divergence

gear or if there are discrepancies. Its when T discrepancies appear that an alert to a probable change in trend is given. Most traders are familiar with the concept of momentum indicators experiencing positive and negative divergences with price. For instance, as you can see in Figure 1, momen- tum makes a series of declining peaks as the price works its way higher. This indicates that the underlying momentum is gradually dissipating, signaling that a peak in the price may be at hand. The opposite set of conditions would be true for a declining trend. The problem with divergences is that you never know how many to expect prior to the actual trend reversal. An unusual but normally reliable discrepancy occurs when

are

moving

in

F IG U R 1: N O R M L D IV E R G E N C ND P R IC E M o m e n m m a k e a s e rie o f E A EA . tu s s de clin in p ea k (lo w e p lo tlin ) as the p ric (u pp e p lo tlin ) w ork its w ay h ig he r. g s r e e r e s T h s d iverg enec ind ica te tha the un de rlyin m o m e n tu is g ra du ay d is sip a ting , i s t g m ll sign a lin th a a pe ak in the price m ay be at ha nd T he op po s e s et of c o nd itio n s g t . it w o ud be true for a d e c lin in tre n d. l g

price and momentum switch roles (where the price leads the momentum indicator), the opposite of the normal situation just described. Thats why I refer to this phenomenon as a

A Price

Momentum

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P r i c e t r e

nd confirmation

1 1

Stocks & Commodities V.15:12 (568-571): Reverse Divergences and Momentum by Martin J. Pring B
Price

Price trend confirmati on

A Momentum F IG U R 2: R E V E RE D IV E R G E N .CT hi ch ar sh o w a reve rs d ive rge necat a E S E s t s e m arke pe a k w h e price and m om en tu sw itc ro le s the o pp o sit of the n orm a l t , n m h , e situ a tio sho w in F ig u e 1. T he pric m a ke its h igh at po in A, then m a ke a n n r e s t s lo w e r h ig at p o in B, but the o scilla tom a ke a h ig he h igh at B. T he fa ct that h t r s r the o sc illa to r p ea k B as the price is de clin in is w h a m a ke th is a reve rs s at g t s e d iv erg en ce . B F IG U R 3: P R IC T R E N C O N F IR M A T IOH e res a re vers d iverg enecin a ctio n E E D . N e at a m a rke b ottom P ric m a ke its final low at p o in A; ho w e verthe o scilla to r t . e s t , bo tto m at p o in B. T h s re la tio n sh ia pp e ar to w or so c on siste n tlbe ca u e the s t i p s k y s m a rke s m o ve m e n ta re d ete rm ind by m a n d ifferen cy clica c o m p o ne n,ts nd t s e y t l a an in d ivid u a l oscilla to o ny re fle ct a v e ry s m all p art of th at p ictu re T he cy cl r l s . e len g th d om in agtin o scilla tow ill d ep e n on the time s p an of the o s cilla torso the r d , the lon g er th time s pa n the lon g e the cy cle . e , r

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reverse divergence. Figure 2 shows a reverse divergence at a market peak. See how the price makes its high at point A, then makes a lower high at point B, but the oscillator makes a higher high at B. The fact that the oscillator peaks at B as the price is declining is what makes this a reverse divergence. Of course, reverse divergences can also fail, so I like to see some kind of trend reversal in the price as a confirmation. Ive used trendlines in these examples, but a reliable moving average crossover works just as well. Figure 3 shows a reverse divergence in action at a market bottom. Note how the price makes its final low at point A,

MIKE YAPPS

but the oscillator bottoms at point B. This phenomenon appears to work so consistently

because prices are determined by many different cyclic rhythms, and an individual oscillator only reflects a very small part of that picture. The type of cycle being reflected will, of course, depend on the time span of the oscillator, so the longer the time span, the longer the cycle. When a price peaks or troughs ahead of the ideal cycle turning point, it indicates underlying strength or weakness, depending on whether its in a downtrend or uptrend. Perhaps some other cycle not reflected by the specific momentum indicator being monitored has now become dominant. At any rate, when the price peaks or bottoms ahead of the oscillator, there is a strong possibility that a trend reversal will materialize.

Price

Price at same level

Price

Price trend confirmation

Momentum rises Momentum

Price trend confirmation

Momentum

Price at same level

Momentum declining F IG U R 4: R E V E RES D IV E R G E E CIN A T R A D IN R A N G E O c ca sio na ,lly E N G . a reve rs d ive rge necde v e lop w h il the m a rk e is in a tra d in ra ng e H ere the p rice e s e t g . , is trad in up ag a in t a res ista ne tre n d lineand e a ch pe ak is at the s a me le ve l. g s c , H ow eve rthe o s cilla to is n ot c on stra inde by a h orizo n tatre nd lin and m a ke a , r l e s h ig he pe ak to w ad the e nd of the trad in ra ng e T h s type of reve rs d iv erg enecis r r g . i e typ icay fo llow e by a tren re v ersa l. ll d d F IG U R 5: F A L L IN TO N EW L O W S D u rin a b o tto m in p ro c e ss a reve rse E G . g g , d ive rge nec o cc ur w he the price k ee p fa llin to the same le ve of s u pp o rt bu t s n s g l , som ew he ra lo n the lin e, the o scilla tofa lls to a new low . e g r

Since the price is determined by the interaction of many different time cycles, its important to plot several momentum indicators with differing time spans for any given situa- tion. This is because the relationship between price and momentum reflected in the reverse divergence will probably only be apparent in one or two of the indicators. Sometimes, the reverse divergence develops in a trading range environment. In Figure 4, the price is bumping against a resistance trendline and each peak is at the same level. However, the oscillator is not constrained by a horizontal trendline and makes its peak toward the end of the trading range. This type of reverse divergence is typically followed by a trend reversal. Finally, another valid form of reverse divergence occurs when the same sort of pattern develops at a bottom, where the price keeps falling to the same level of support, but somewhere along the line, the oscillator falls to a new low (Figure 5).
METASTOCK FOR WINDOWS (EQUIS INTERNATIONAL)

TO CONSIDER
Bear in mind that the significance of the trend being reversed will depend on the time span of the oscillator. An oscillator constructed from monthly data will have greater trend rever- sal potential than one constructed from daily data. Further, reverse divergences can be observed in many different types of momentum indicators with a jagged appearance. Ex- amples include the relative strength index (RSI), the Chande momentum oscillator and the demand index. I prefer the rate of change (ROC).

Since the price is determine by d the interaction of many different time cycles, its important to plot several momentu indicator with m s differing time spans for any given situation.

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Its important to note, however, that reverse divergences are only valid for raw data because the smoothing process automatically delays turning points, so the turning point for the price often occurs after the smoothed momentum has reversed direction. To get a reverse divergence at a top requires two peaks for the price and two for the indicator. It works the same way for bottoms.

IN THE MARKETPLACE
Figure 6 features the British pound with a 39-week ROC. If F IG U R 6: B R IT IS P O U N A ND 3 9 -W EK R O C At the e nd of 1 9 8 6 y ou c an E H D E . , you look closely at the end of 1986, you can see the arrow see the arrow m arkingthe m om entum is slightlyto the right of the arrow low marking the momentum low is just slightly to the right of m arking the price low . In 1989, the currency w as form ing the second bottom in a double- bottom form ation at a tim e w hen the oscillator w as touching a the arrow marking the price low. In 1989, the currency was m ultiyear forming the second bottom in a double-bottom formation at low . a time when the oscillator was touching a multiyear low.

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4 4

F IG U R 7: L U B YS C A F E T E RS A ND 4 5 -D A R O C T h s v a riatio on the E IA Y . i n reve rs d iverg enecprin cip l is an e xam p l of the d iverg en cen ot ap pe a rin after e e e s g an a d va ne or de c lin but h a v in b ee form e du rin a tra d in ran ge L ub y s c e g n d g g . tra d e sid ew as in the su m m r a nd e arl fa l of 1 99 4 T he p ric w as u na be to d y e y . e l ra lly a boevthe re sis tane tren d lin,ea ltho u h the 4 5-d a R OC w as ab e to m a k c g y l e a ne w h ig in A ug u stS ep tem bre nd O ctob e. rT h s ra lly w as fo llow d by a s m all h , a i e d e clin e an a no the trad in ra ng e D u rin the se con trad in ra ng e the s a me d r g . g d g , situ a tion o ccurre the p ric w as u na be to b re a to the u p side a ltho u h the d as e l k , g R OC d id. A ll thsi w as fo llo w e by a fa irl se v er d e clin e. d y e

F IG U R 8: E M E R SN E L E C T R IA ND 1 0 -D A R O C R e v e rs d iv e rg e n c eap p ly E O C Y . e s to a l time sp an s S ee how the p ric de clin s in m id -A plrias the 1 0-d a R O C . e e y co n tin us to ra lly and is then fo llo w e by a de c lin . U nfortun a te ly er w as e d e , th e n oth in gnithe w ay of a p ric tre n co n firm a tio n e v ers d ive rge n c eare u nu su a l e d .R e s , b ut the y ar an o th e p ote n tiato o for your te c hn iclaa rse na lD ont forg e th ey can e r l l . t a lso be u se w ith m o vin a ve ra g cro s so v eras w e ll. d g e s

The same thing happened in mid-1993. That time, the second price low was higher than the first, but momentum made its low at the second bottom. The pound did experience a move to the $1.70 area later, but the change in trend following this reverse divergence was from down to sideways, since the currency held above the 1993 low for many years. Figure 7 shows another example of a reverse divergence in action. Lubys Cafeterias experienced a sideways trading range in the sum 1994. The price was una resistance trendline, altho was able to make a new h tember and October. This r small decline and anoth second trading range, the s price was unable to break t ROC did. All this was f severe decline. This is als on the reverse divergence because the divergences come after an advance or cline but were formed dur a trading range. You may think that r verse divergences are limited to momentum indicators with a longer time frame long enough t peak or trough after the pri series but this principle a plies to all time spans.

Fig 8 features a 10-day ROC

the price declines in mid-April as the ROC continues to rally and is then followed by a decline. Unfortunately, there was nothing in the way of a price trend confirmation. Reverse divergences are unusual, but they are another potential tool for your technical arsenal. Dont forget they can also be used with moving average crossovers as well. But like everything else, they do fail sometimes, so dont forget to get a trend reversal in the price for mation . ng is the author of a number of ublishes The Intermarket Reand is a principal of the invest- ounseling firm PringTurner Group. Emerson Electric. Look h

TED READING

Martin J. [1992]. The All-Seavestor, John Wiley & Sons. _ [1985]. Technical Analysis Ex- ned, McGraw-Hill Book Co. [1992]. Rate of change, echnical Analysis of STOCKS & OMMODITIES, Volume 10: Aut. [1992]. Identifying trends ith the KST indicator, Technical Analysis of STOCKS & COMMODITIES, Volume 10: October.

See Traders Glossary for definition

S &C

mer and early fall of ble to rally above the ugh the 45-day ROC igh in August, Sepally was followed view er trading range. During the ame situation occurred Capital o the upside, although the ollowed by a fairly a variation principle didnt deing e-

confir Martin Pri books, p by a as ment c the

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