Diamonds And Divergences

04/05/05 11:02:36 AM

by David Penn

Once again, stochastic divergences help anticipate the direction of a chart pattern breakout.

Security: $SPX
Position: N/A

I've been beating the drum for months about the idea of combining technical indicators and chart patterns. One of my favorites, for example, is negative stochastic divergences and 2B tops. On its own, each is a powerful signal that a reversal may be imminent. When used together, they can help buttress an argument for a successful entry, timely exit, or a key observation for further notice.

Tuesday, April 5's action in the Standard & Poor's 500 provided another instance of technical indicators and chart patterns working well together. To set the scene, the S&P had been in a bearish trend for March. By late March/early April, the S&P 500 was making a major test of support in the 1160s. What was significant about this support level was the fact that it marked both the previous lows in January, as well as being part of a support trendline that extends all the way to the beginning of the current advance back in August 2004.

Figure 1: The positive stochastic divergence shown here on Tuesday, April 5, helped anticipate the bullish breakout in this intraday diamond (30-minute chart).

Graphic provided by: Prophet Financial, Inc.

Some people have a thing for certain patterns, and it appears as if, for me, diamonds are forever. In any event, it was a diamond that I saw in the consolidation that occurred as the S&P 500 made its second major test of support in the 1160s. Diamond consolidations are simply sideways price action bounded by two pairs of parallel trendlines. The overall effect looks like a diamond or a parallelogram.

Breakouts from diamonds can go to the upside or the downside--making the diamond, potentially, a reversal or a continuation pattern. To make matters even more complicated, some diamond breakouts fake a move in one direction, find resistance at the top or bottom level of the pattern, and then reverse to move aggressively in the other direction. All of this makes diamond patterns particularly tricky to trade.

This is where technical indicators can be helpful. Note how, as the low of the diamond pattern is made, the 7,10 stochastic is registering a higher low. This means that a positive stochastic divergence has developed between the S&P 500 and the stochastic--and that higher prices (or at a minimum, no significantly lower prices) are likely going forward. Further, in this context, that positive stochastic divergence also suggests that breakout from the diamond will be to the upside.

After a brief, breakout feint to the downside, the S&P 500 reversed and moved strongly higher, climbing more than eight points from the post-break low in little over two hours.

How much upside could traders expect from this diamond? The formation size added to the value at the breakout level is the basic measurement rule for diamond patterns. Here, a formation size of about 7 would be added to a value at the breakout. If you chose to use the initial downside feint as the breakout, then your breakout value would be about 1170, which would provide for a minimum upside of 1177. If you chose instead to use the area where the upside boundary of the diamond was broken, then your breakout value would be closer to 1172, which would provide for a minimum upside of 1179.

In the first case, the minimum objective was reached by the end of the trading day. In the second case, the minimum objective was reached within the first few minutes of the following day. But in both instances, the combination technical indicators and chart patterns provided an excellent intraday opportunity for traders working in that time frame.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Diamonds And Divergences

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