Slope Divergence: Capitalizing On Uncertainty by Perry J. Kaufman
Which Direction Is It Going?
It’s a classic chart pattern and many traders use it, yet divergence patterns that could generate profits are easy to miss. Here’s one way to automate identifying profit-making divergence patterns.
A divergence occurs when two related markets — such as Apple (AAPL) and Hewlett-Packard (HP), or the S&P 500 index and the utilities index — move away from each other. Traders have every expectation that these markets will come back together because they are driven by the same underlying fundamentals, which, in most cases, is the health of the economy.
Technical divergence is when the price of a stock and a momentum indicator calculated on that stock move away from each other. In the chart in Figure 1, the 14-day stochastic indicator (smoothed once) is applied to the S&P 500 SPDR (SPY). You’ll see that there are three occasions where a divergence took place: two where prices rose and the stochastic fell; and one, in the center, where the stochastic rose and prices fell. A bearish divergence, which is when prices rise, is expected to be resolved by a price decline, and a bullish divergence with a price rise. Therefore, expectations are that the momentum determines the direction. This is true regardless of which momentum indicator you use — such as a stochastic oscillator, the relative strength index (RSI), or the moving average convergence/divergence (MACD).