• 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