Lessons from the Pros

India Markets

Technical Odds Enhancer

Today I will discuss technical indicators as an odds enhancer. 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 included on some. If you understand the mechanics of the indicator, then you know how it is likely to read and when it will give signals just from reading price on a chart. If 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. However, indicators can be helpful when used properly. Since the buy or sell signals usually show late, we must observe the behavior of the indicator and take our signals from changes in that behavior. Enter divergence. Divergence is when the indicator is not exhibiting the same characteristics as the price of the security. When prices rise, you should be seeing higher highs and higher lows for the uptrend in price. 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 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.

axis positive div

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 MACD. Note that the divergence can occur in the MACD itself or the histogram to be effective.

macd div

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. This lack of momentum being demonstrated by price and reflected in the indicator is a signal of weakness of the trend. Be watchful for reversal signals in this environment.

nifty negative div

So while indicators should not be used as a decision making tool alone, they can be used to confirm your trading decisions. Seeing divergence while price is at a supply or demand zone shows that the level is more likely to hold. As traders we should seek to find the highest probability trading opportunities for the best results.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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