In the last post we built an oscillator for our trading system. The indicator found the tops and bottoms quite easily. From my trading experience that’s one of the best ways to use an oscillator — find the extremes. But there is a second and equally illuminating method to gain information, a term you’ve probably heard — divergences.
For those that haven’t heard about divergences here’s a quick explanation. A divergence in its simplest form is a non-conformation of current information — that there is a disagreement between two data sets.
Divergences can be very powerful trading indicators. Let’s start drilling down into this information.
This chart has the custom ROC plotted below price. The area in the box shows an agreement between price and the ROC. This is not a divergence. Price moved up in late November in a series of higher highs. The ROC does the same and agrees with, or confirms price (click the chart for a closer look).
This is an example of a bearish divergence: price moves higher, but the oscillator doesn’t confirm it. When this appears be on the lookout for a price decline.
A bullish divergence is the opposite: price moves lower, but the oscillator doesn’t confirm it by moving lower, too. Price is likely to move higher when you see this pattern.
In early 2009 there was a very obvious bullish divergence that appeared on all of the major averages. This is that time frame on the NASDAQ Composite. You surely could have profited if you’d seen this pattern!
Now you have a couple of ways to use the custom ROC — finding tops and bottoms, and spotting divergences. In the next post, I’ll show you how adding a “second opinion” will enhance your confidence in this stock trading system.
