Trading Divergence and Understanding Momentum

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Trading Divergence and Understanding Momentum

Because trends are made up of a succession of price swings, momentum is important in determining trend strength. As a result, it is critical to recognize when a trend is slowing. Less momentum does not automatically indicate a reversal, but it does indicate that something is happening and that the trend may consolidate or reverse.

The direction and magnitude of price are referred to as price momentum. Price swing comparison allows traders to acquire insight into price momentum. Here, we’ll look at how to measure price momentum and what divergence in momentum might tell you about a trend’s direction.

Key Takeaways

  • Price momentum is assessed by the duration of short-term price fluctuations—steep slopes and lengthy price swings imply high momentum, whereas shallow slopes and short price swings represent weak momentum.
  • The relative strength index, stochastics, and rate of change are all momentum indicators.
  • Divergence, or disagreement between indicators, may have serious consequences for trade management.

Defining Price Momentum

The duration of short-term price fluctuations measures the level of price momentum. Structural price pivots, which produce swing highs and lows, define the start and finish of each swing. A high slope and an extended price swing indicate strong momentum. A small slope and brief price swing indicate weak momentum.

Image by Julie Bang © Investopedia 2019

The length of an uptrend’s upswings, for example, may be quantified. Longer upswings indicate that the uptrend is gaining speed or strength. Shorter upswings indicate a loss of momentum and trend strength. Equal-length upswings indicate that momentum stays constant.

Price movements are difficult to assess with the naked eye since prices might be choppy. Momentum indicators are often used to smooth out price activity and provide a more clear picture. They enable the trader to compare indicator swings to price swings rather than price to price.

Momentum Indicators

The relative strength index (RSI), stochastics, and rate of change are popular momentum indicators for assessing price fluctuations (ROC).Figure 2 shows how the RSI may be used to calculate momentum. RSI is set to 14 by default. The RSI has set bounds and a value range of 0 to 100.

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Momentum can be calculated by using the formula:

M = CP – CPx

Where CP is the current closing price and CPx is the closing price “x” periods ago.

Each price increase is accompanied by an increase in the RSI. When the price falls, so does the RSI.

Figure 2: Generally, indicator swings follow the direction of price swings (A).To compare the momentum of price and the indicator, trendlines may be formed on swing highs (B) and lows (C).

Source: TDAmeritrade Strategy Desk

The analysis of momentum simply determines whether or not the price and the indicator coincide.

Figure 3: Use price and indication comparison to make better trading choices.

Source: TDAmeritrade Strategy Desk

Momentum Divergence

Divergence is the difference between the indicator and the price, and it may have serious consequences for trading management. Because the degree of agreement/disagreement is relative, many patterns might emerge in the connection between price and the indicator. The material in this article is restricted to the most fundamental types of divergence.

It is vital to remember that price movements of significant magnitude must exist in order for momentum analysis to be meaningful. As a result, momentum is effective in active trends but not in range circumstances, when price movements are restricted and varied, as seen in Figure 4.

Figure 4: The indicator does not contribute to what we observe from price alone under range situations. Variable pivot highs and lows demonstrate range.

Source: TDAmeritrade Strategy Desk

In an uptrend, divergence happens when the price achieves a higher high but the indicator does not. Divergence happens in a downtrend when the price makes a lower bottom but the indicator does not. When divergence is detected, the likelihood of a price retracement increases. Figure 5 shows divergence, not a reversal, but a shift in trend direction to sideways.

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Momentum divergence and a retreat are seen in Figure 5. Price support is indicated by higher pivot highs (little orange arrows).

Source: TDAmeritrade Strategy Desk

Divergence assists traders in recognizing and reacting effectively to price movement changes. It indicates that something is changing and that the trader has to make a choice, such as tightening the stop-loss or taking profit. The presence of divergence promotes profitability by alerting the trader to the need to safeguard gains.

Divergence is often used by technical traders when the price moves in the opposite direction of a technical indicator.

Take notice of the company in Figure 5, Chesapeake Energy (CHK), whose shares have returned to the support level. The graph in Figure 6 (below) indicates that trends do not reverse rapidly or often. As a result, we earn the most when we recognize trend momentum and apply it to the proper approach at the right time.

Figure 6: The trend continues. An entry is made when the price and the indication agree (small green arrows).

Source: TDAmeritrade Strategy Desk

Four Commonly Used Indicators In Trend Trading

Managing Divergence

Divergence is critical in trade management. Taking profit or selling a call option were both good tactics in Figure 5. The disparity between the price and the indicator caused a retreat, after which the trend resumed. When the price pivots below the lower trendline, this is commonly referred to as a bear trap, since the misleading signal brings in shorts and the price swiftly reverses. When the higher low in price coincided with the higher low of the indicator in Figure 6, the signal to enter came (small green arrows).

Divergence signals that something is changing, but it does not always imply that the trend will reverse. It indicates that the trader should think about strategy choices like as holding, selling a covered call, tightening the stop, or taking partial gains. The allure of being able to select the top or bottom is motivated by ego rather than profit. To be consistently successful, we must choose the best strategy for what the price is doing, not what we believe the price will do.

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Figure 7: Divergence results in range.

Source: TDAmeritrade Strategy Desk

Figure 7 depicts a divergence that results in sideways price movement. As the price enters a range, the momentum in moving average convergence divergence (MACD) weakens. This indicates that the trader should think about strategy choices. We have a disagreement or divergence when the price and the indication are discordant with each other. We have no influence over what the pricing does. Instead, we only have control over our own acts.

Figure 8: Divergence and then reversal of trend.

Source: TDAmeritrade Strategy Desk

Divergence may sometimes result in a trend reversal, as seen in Figure 8. Figure 9 depicts the Utilities Select Sector SPDR (XLU), which pays a dividend and includes options. Understanding trend momentum provides investors with a competitive advantage since there are three methods to earn in this market: capital gains, dividends, and call premium. This example demonstrates trend continuance after a sideways move, which equates into profit retention.

Figure 9: When the price and the indication concur, follow the trend.

Source: TDAmeritrade Strategy Desk

The Bottom Line

Knowing what technique to apply is the most beneficial method to utilize a momentum indicator. Price will lead the way, but momentum may imply that it is time to lock in gains. A skilled trader’s competence resides in their ability to apply the proper price action plan.

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