Business divergence and drive for understanding

Since trends are made up of a series of price swings, momentum plays a key role in assessing the strength of the trend. As such, it is important to know when a trend is slowing down. A lower momentum does not always lead to a reversal, but it does indicate that something is changing and the trend may consolidate or reverse.

Price momentum refers to the direction and magnitude of the price. Comparing price swings helps traders better understand price momentum. Here, we will look at how to assess price momentum and show you what divergence in momentum can tell you about the direction of a trend.

Key takeaways

  • Price momentum is measured by the duration of short-term price swings: steep slopes and long price swings represent strong momentum, while weak momentum is represented by a shallow slope and a change of short prices.
  • Momentum indicators include the Relative Strength Index, Stochastic, and the exchange rate.
  • Divergence (disagreement between indicators) can have important implications for trade management.

Definition of price dynamics

The magnitude of the price momentum is measured by the duration of short-term price swings. The beginning and end of each swing are set by structural price pivots, which form ups and downs. Strong momentum is manifested by a steep slope and a prolonged price swing. Weak momentum is observed with a shallow slope and a short price swing.

Image by Julie Bang © Investopedia 2019

For example, you can measure the duration of rallies in an uptrend. Longer rallies suggest that the uptrend is showing greater momentum or is strengthening. Shorter rallies signify weakening momentum and trend strength. Increases of equal length mean that the momentum remains the same.

Price changes are not always easy to assess with the naked eye because the price can vary. Momentum indicators are commonly used to smooth price action and provide a clearer picture. They allow the trader to compare indicator changes with price changes, rather than having to compare price to price.

Moment indicators

Common momentum indicators for measuring price movements include the Relative Strength Index (RSI), Stochastic, and Rate of Change (ROC). Figure 2 is an example of how the RSI is used to measure momentum. The default setting for RSI is 14. RSI has fixed limits with values ​​ranging from 0 to 100.

The moment can be calculated using the formula:

M = CP – CPx

Where CP is the closing price and CPx is the closing price “x” number of previous periods.

For every increase in price, there is a similar increase in RSI. When the price goes down, the RSI goes down as well.

Figure 2: Indicator changes generally follow the direction of price changes (A). Trend lines can be drawn at the highs and lows (B) and the lows (C) to compare the momentum between the price and the indicator.

Source: TDAmeritrade Strategy Desk

The momentum study simply checks whether the price and the indicator agree or disagree.

Figure 3: Compare price and indicator to make better trading decisions.

Source: TDAmeritrade Strategy Desk

Moment divergence

Disagreement between the indicator and the price is called divergence and can have important implications for business management. The amount of agreement / disagreement is relative, so there may be several different patterns that develop in the relationship between the price and the indicator. For this article, the discussion is limited to the basic forms of divergence.

It is important to note that there must be strong enough price swings for the momentum analysis to be valid. Therefore, momentum is useful in active trends, but not useful in range conditions where price swings are limited and variable, as shown in Figure 4.

Figure 4: In range conditions, the indicator does not add to what we see only in price. The highs and lows of the variable pivot show the range.

Source: TDAmeritrade Strategy Desk

Divergence in an uptrend occurs when the price reaches a higher high, but the indicator does not. In a downtrend, divergence occurs when the price goes down, but the indicator does not. When a divergence is detected, there is a higher probability that the price will turn back. Figure 5 is an example of divergence and not a reversal, but a change in direction of the trend sideways.

Figure 5: Divergence of the moment and setback. Higher pivot highs (small orange arrows) indicate price support.

Source: TDAmeritrade Strategy Desk

Divergence helps the trader to recognize and react appropriately to a change in price action. It tells us that something is changing and that the trader must make a decision, such as adjusting the stop loss or taking profit. Seeing the divergence increases profitability by alerting the trader to protect profits.

Technical traders generally use divergence when price moves in the opposite direction of a technical indicator.

Take note of the action in Figure 5, Chesapeake Energy (CHK), in which stocks fell back to support. The graph in Figure 6 (below) shows that trends do not reverse quickly, or even frequently. Therefore, we make the best profits when we understand the momentum of the trend and use it for the right strategy at the right time.

Figure 6: Continuation of the trend. The agreement between the price and the indicator gives an input (small green arrows).

Source: TDAmeritrade Strategy Desk

Four Commonly Used Indicators in Trend Trading

Managing divergence

Divergence is important for business management. In Figure 5, making a profit or selling a call option were good strategies. The divergence between the price and the indicator caused a pullback, then the trend continued. If you watch the pivot that makes the price below the lower trend line, this is often called a bearish trap, where the false signal draws shorts and the price reverses quickly. The signal to enter appeared when the highest low in price coincided with the highest low of the indicator in Figure 6 (small green arrows).

Divergence indicates that something is changing, but it does not mean that the trend will reverse. Indicates that the trader should consider strategic options: hold, sell a covered call, adjust the stop or obtain partial profits. The glamor of wanting to choose between the best or the last has more to do with the ego than with the profits. Being consistently profitable is choosing the right strategy for what the price is doing, not what we think the price will do.

Figure 7: Range divergence results.

Source: TDAmeritrade Strategy Desk

Figure 7 shows a divergence leading to sideways price action. Watch the momentum weaken in Moving Average Convergence Divergence (MACD) as price enters a range. This indicates that the trader must consider strategic options. When the price and the indicator are inconsistent with each other, we have a disagreement or divergence. We are not in control of what the price will do. Instead, we only control our own actions.

Figure 8: Divergence and then trend reversal.

Source: TDAmeritrade Strategy Desk

Sometimes the divergence will lead to a trend reversal, as shown in Figure 8. The utility selection sector (XLU) SPDR shown in Figure 9 pays a dividend and has options. Understanding the momentum of the trend gives investors an earnings advantage, as there are three ways to profit here: capital gains, dividends, and buy premium. This example shows the continuation of the trend after a lateral movement, which translates into a continuation of the gains.

Figure 9: Follow the trend when the price and the indicator coincide.

Source: TDAmeritrade Strategy Desk

The bottom line

The most useful way to use a momentum indicator is to know which strategy to use. Price will lead the way, but momentum may signal a time to preserve gains. The skill of a professional trader lies in his ability to implement the correct strategy for price action.

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Mark Holland

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