|In an upcoming article for Working-Money.com, I lay out a method trading stochastic divergences. Essentially, I suggest that taking advantage of the reversals that often follow stochastic divergences (as well as divergences revealed by other oscillators) requires taking a position as early as possible. While it is generally impossible to nail the final tick in a move that is about to reverse, there are ways that can help minimize the distance between the anticipated top (or bottom) and the trader's entry.|
|Let's look at just one type of divergence--the negative stochastic divergence at a potential market top. Typically, many traders play tops with negative divergences by waiting for prices to swing back below the intrapeak pivot low. The scenario tends to be something like this: prices rally, pull back and establish a pivot low, then move on to create a higher high. All the while, the stochastic is showing lower consecutive highs, creating a negative divergence. The conservative way to play such a setup has been to wait for prices to fall back below the pivot low before taking a short position on the downside reversal. A more aggressive approach, however, is to use the bar that establishes the initial high (or low, in the case of a potential positive divergence) as the target and measuring stick for any entry, should prices follow through on the reversal.|
|Figure 1: Daily Nasdaq. The second negative divergence in this daily chart of the Nasdaq may be a charm if prices follow-through to the downside.|
|Graphic provided by: Prophet Financial, Inc.|
|Let's see how this method works. There are two negative stochastic divergences in the Nasdaq chart shown in Figure 1. The first involves the successively higher Nasdaq peaks on November 15 and December 6, matched with the successively lower peaks in the 7,10 stochastic. The second involves the successively higher Nasdaq peaks on December 6 and 15, matched with the successively lower peaks in the 7,10 stochastic.|
Once prices began retreating from the December 6th peak, a retreat that established the negative stochastic divergence, I looked back to the initial peak on November 15. If prices, after December 6, fall below the low of November 15, then I consider the negative stochastic divergence to be confirmed and a short-entry (or going flat) to be a reasonable bet. Actually, I subtract half the range of the November 15th bar from the low of that day to provide a little extra wiggle room. This would call for a short play (or going flat) if the Nasdaq fell to 2071.19 or thereabouts.
|Yes, the Nasdaq rallied, and no short play was triggered. Yet note that the setup called for a potential entry at the 2070 level--a full 20 points higher than the intrapeak pivot low day's low on November 22. If the Nasdaq had indeed fallen after December 6 to the 2070 level, a trader would be some 20 points ahead of the game (and an investor some 20 points richer), compared to the one who waited for the intrapeak low to be penetrated.|
Let's look at the second negative divergence--one that brings us much closer to recent price action. The method is exactly the same. The negative divergence develops as soon as the Nasdaq retreats from the December 15th peak. What will it take for the divergence to be confirmed? Since the divergence is created between December 6 and December 15, I look at the low of December 6 (and that day's range) for my confirmation level. With a low on December 6 of 2138.21 and a daily range of 19.22, I get a negative stochastic divergence confirmation level at 2128.60. In short, if the Nasdaq falls below this level after December 15, then it is a reasonable proposition that the Nasdaq will continue to move lower.
|As of Friday, December 17, the Nasdaq had fallen as low as 2135.05, some six and a half points or so away from the bearish confirmation level.|
Should the Nasdaq hit 2135, then a continued descent should be expected. The duration and extent of any decline is impossible to know--though there is support at the intrapeak pivot lows near 2100 and again at 2050. In the event of a correction in the Nasdaq, it seems likely that these would be levels from which the Nasdaq could bounce, at a minimum.
And, of course, if the Nasdaq fails to retrace to 2135, then it's back to that old bull market magic.
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