- Oscillator Analysis
- Direction
- Area
- Divergences
Three Dimensions Analysis
- Direction – Bullish or Bearish
- Area – Overbought or Oversold
- Divergence – Bullish or Bearish
Direction – Bullish or Bearish
- The same techniques that are used for analyzing price trends can be applied to momentum
- When the indicator goes below its trendline we have the bearish signal
- When the indicator goes below its moving average we have a bearish signal and vice versa
- A trend reversal in momentum is not always associated with a similar reversal in the price – PRICE IS THE BOSS
Area - Overbought & Oversold
- The financial markets are essentially driven by psychological forces
- Our emotions move from one extreme to another, from greed to fear, from hope to despair
- This is what causes momentum indicators to fluctuate from oversold to overbought levels
- Momentum reflects crowd psychology and measures the intensity of the emotions of market participants
- Banded oscillators fluctuate between 0% and 100%
- For RSI and IMI extreme levels are those beyond 70% and 30%
- For Stochastic extreme levels are those beyond 80% and 20%
- Other oscillators are unbanded and traders must manually identify overbought and oversold lines
- Extreme levels are manually determined where the indicator previously topped or bottomed
- Extreme momentum readings indicate a possible correction in price
- Signals are used by some traders to exit or enter new positions against the previous direction
- A bullish signal occurs when the indicator goes below 30 and then crosses above it from below
- A bearish signal occurs when the indicator goes above 70 and then crosses below it from above
Divergences
- Divergences can be seen by comparing the price of a security with the movement of an oscillator
- If price is making higher highs, the oscillator should also be making higher highs, and vice versa
- If they are NOT, that means the price and the oscillator are diverging and that’s why it’s called “divergence”
- Divergence serves as a warning that the trend is about to change or a correction is imminent
Types of Divergences
- Classic
- Hidden
- Complex
Classic Divergences - Bullish
- If price is making lower lows, but the oscillator is not, this is considered to be bullish divergence
- This normally occurs at the end of a downtrend and can sometimes signal that the price will rise
- It is also called positive divergence because the technical position is said to be improving
Classic Divergences - Bearish
- If the price is making a higher high, but the oscillator is not, then we have bearish divergence
- This normally occurs at the end of an uptrend and can sometimes signal that the price will drop
- It is also called negative divergence because the technical position is said to be deteriorating
Divergences - Interpretation
- Momentum oscillators serve as a leading indicator and divergences are used when detecting tops and bottoms
- Momentum reversal precedes reversals in price and is regarded as a warning of a possible price reversal
- However not all divergences result in good signals especially during a strong trend
Hidden Divergences - Bullish
- Hidden bearish divergence occurs when the price fails to move higher but the oscillator rises
- This normally occurs at the end of an uptrend and can signal a bearish trend reversal
Complex Divergences
- Price trends are determined by the interaction of different time cycles
- Most momentum oscillators, reflect only one cycle, since they are constructed using a specific look-back period
- To reflect more than one cycle we should compare two momentum indicators constructed from two different periods
- Complex divergence is a divergence between two oscillators of different periods instead of an oscillator and price
Complex Divergences - Bullish
- When the shorter starts to rise and the longer continues to a new low, cycles are “out of synch”
- This normally occurs at the end of a downtrend and can signal a bullish trend reversal
Complex Divergences - Bearish
- When the shorter starts to drop and the longer continues to a new high, cycles are “out of synch”
- This normally occurs at the end of an uptrend and can signal a bearish trend reversal
Divergences - Strength
- The more the divergences, the greater their significance
- Failure of the price to correct after a divergence, indicates that when the correction begins, it will be much more severe
- The greater the time between one divergence and another, the greater their significance
- Divergences in a longer period oscillator are considered more important than divergences in a shorter period oscillator
- Closeness to Equilibrium
- The value of the oscillator at the time of the divergence is very important
- The closer the oscillator is to equilibrium, the larger is the expected sell-off
Divergences - Trap
- Most of the time, divergences proceed in a fairly orderly way
- A final directional wave develops and pushes the oscillator back beyond its previous level
- This move will prove to be a “divergence trap” after which price will reverse as previously expected
- When the short covering process ends, reverse as previously expected
Divergences - Summary
- Classic divergence occurs when price makes a new high/low but the oscillator does not
- Hidden divergence occurs when the oscillator makes a new high/low but the price does not
- Complex divergence occurs when the longer period oscillator makes a new high/low but the shorter period oscillator does not
- Look for bearish divergences in uptrends and bullish divergences in downtrends, in a range they do not work well
- Divergences do not represent actual buy or sell signals but act as an early warning of a possible price reversal
