Divergence- the best technical indicator

Divergence

A divergence is a move in the price of an asset not confirmed by a comparable move in the applied technical indicator. For example, a bullish divergence exists when a market reaches a new low without the indicator reaching a corresponding new low. Conversely, a bearish divergence exists when a market reaches a new high without the indicator reaching a corresponding new high.

In my opinion, divergence is the most predictive of all the indicators. It will be early more often than not. Early can be very painful. A popular stock market tidbit of wisdom reads like this: “What’s the difference between being early and wrong? None.”

That being said let me show you how I interpret divergence. First of all I only look at a version of Wilder’s relative strength index when I’m examining divergence. Developed by J. Welles Wilder, the Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. Before we get too far into this, let’s rehash the popular version of what this indicator does because I dont’ use it in the way most people do.

Relative Strength Index 14-period

The RSI is presented on a graph above or below the price chart. The indicator has an upper line, typically at 70, a lower line at 30, and a dashed mid-line at 50. Wilder believed that when price moves up very rapidly, at some point it is considered over-bought. Likewise, when price falls very rapidly, at some point it is considered oversold. In either case, Wilder deemed a reaction or reversal imminent.

The level of the RSI is a measure of the stock’s recent trading strength. The slope of the RSI is directly proportional to the velocity of a change in the trend. The distance traveled by the RSI is proportional to the magnitude of the move.

Wilder believed that tops and bottoms are indicated when RSI goes above 70 or drops below 30. Traditionally, RSI readings greater than the 70 level are considered to be in overbought territory, and RSI readings lower than the 30 level are considered to be in oversold territory. In between the 30 and 70 level is considered neutral, with the 50 level a sign of no trend. For those of you that want a formula and further explanation of how Wilder’s RSI is calculated and graphed, please click on this excellent explanation from StockCharts.com.

So as an oscillator, I pay no attention at all to this theory. I dont’ believe very much in oscillators in general although I use popular ones like stochastic in my charts every day. More on that later but let me say you should know and recognize what other people see when they read charts. You dont’ have to believe in Christianity or Islam to know that millions do.

Divergence

What appears to work well for me is that Wilder further believed that divergence between RSI and price action is a very strong indication that a market turning point is imminent. Bearish divergence occurs when price makes a new high but the RSI makes a lower high, thus failing to confirm. Bullish divergence occurs when price makes a new low but RSI makes a higher low. Let me illustrate how this works with this chart of Apple Computer. I use TradeStation’s popular charting software and a proprietary version of Wilder’s RSI that I had coded in their programming language, Easy Language.

As you can see, in this screen capture and the accompanying video,Apple Computer stock appears to be range bound for several months between April 2010 and August 2010. Then on August 25, and then again on August 27th my indicator fired off a green dot indicating divergence. It fired off a very early green paint sign a month earlier that created brief profits before being reversed. As you can see from the chart, there is a very dramatic divergence between the price action which is still trending down or flat and Wilder’s RSI which is beginning to rocket up. This is a very clear divergence and led to a dramatic 80 point rise in the stock before exhausting itself. This is a classic bullish divergence.

Starting though around October 18th, Apple begins to show dramatic bearish divergence. This was an early warning for traders to exit or even short sell the stock. Although I wouldn’t want to short a stock with such obvious good prospects. At a minimum Apple was dead money for a month or so after this signal.

Expanding the chart to view the price action in 2011, shows two more divergences. Another bearish one and then a positive one. Actually there are several bearish red dots but like I mentioned earlier, this proprietary indicator I had coded is not perfect. Although I had it programmed to fire off buys and sells automatically, it never proved accurate enough to do that. I still have to see the chart and analyze multiple factors before I make a decision on buying or selling. I tend to only use the red and green dots (known as paints in the TradeStation platform) as a tool to grab my attention. What I really focus on is the trend of the Wilder’s RSI line. It is it diverging from the price action?

As you can see when Apple topped out on March 7th, its RSI line had already turned down. This was a classic bearish divergence. Then for the first time on April 15th and April 18th, Apple showed clear bullish divergence both in the RSI line and on my indicator with positive green posts. In fact I blogged about this widely and Apple rewarded me with a quick 20-30 point gain depending on when you entered. And what has Apple done lately? It’s not a pretty picture if you are long at the moment. I’m not of course because my charts have taken me out.

A couple important points to remember:

1. The period you set your indicators too will have a tremendous impact on your outcomes.   I for one use a short period on the Wilder’s RSI indicator (just seven days).  I’ve found that’s what works best for me with my style of investing.  Others may find better results with different periods.  Wilder himself suggested a 14 day average to begin the calculations.   Also I use daily charts.  Weekly charts, monthly charts or even 2 minute charts will all likely have very different results.
2. RSI divergence as do most oscillator type indicators work best in markets that are going up and down or range bound.  Stocks that are breaking out or breaking down can trend in a particular direction for longer periods of time and make these types of indicators less useful.  Technical analysis when used for profitable gain,  is just one piece of the picture.  A slight edge in investing can yield enormous results.   Dont’ fall victim to the dogma that all known and future expectations are already revealed by the stock’s chart.  One piece of news can often blow apart the prettiest of chart patterns.