Trading decisions should be based on price action and volume. Technical indicators are very popular in the trading community but need to be used only as an odds enhancers. It is important to remember that an odds enhancer is used to increase the probability of a trade working out, not to signal the entrance to a trade itself. You should still execute trades based on price analysis and supply and demand levels. Whenever I start to discuss technical indicators, everyone always asks me what my favorite one is. I never get bored from watching the disappointment on their faces when I answer, “Price!”
The truth is, all indicators are built on past price and relationships to that price with volume sometimes included. If you understand the mechanics of the indicator, then you know how it is likely to read price movement and when the indicator will give signals by simply reading price on a chart. When you can do this, then you will be ahead of those who are relying on an indicator to render a buy or sell signal prior to acting. Indicators can be helpful when used properly. Since the buy or sell signals usually appear late, we must observe the behavior of the indicator and take our signals from changes in that behavior.
Divergence is when an indicator does not exhibit the same characteristics as the price of the security. When prices rise, you should be seeing higher highs and higher lows for the price trend. You should also be seeing higher highs being made in the indicators. The opposite is true when in a downtrend -- lower lows in price and in the indicator. There are two types of divergence, positive and negative. Positive divergence typically signals the pause or end of a downtrend. In positive divergence, the price of the security makes lower lows and lower highs, a downtrend. However, the indicator makes the same lows or possibly higher lows.
The divergence of the indicator shows that even though prices are continuing in the trend, they are doing so with less momentum and are unlikely to continue without a pause, correction, or even a reversal. This is shown in the following chart with positive divergence in the Stochastics.
Negative divergence typically signals the end, pause, or correction of an uptrend. It occurs when prices are making higher highs and higher lows (an uptrend), but the indicator makes similar or lower highs. A lack of momentum demonstrated by price and reflected in the indicator is a signal of trend weakness. Be watchful for reversal signals in this environment.
A trader can use technical indicators, but make sure to use them properly. Relying on them to signal your entry or exit into trades could lead to disaster. Looking for divergence to confirm your trade that was based on price action is the best way.
Editor's note: This story by Brandon Wendell originally appeared on Online Trading Academy
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No positions in stocks mentioned.