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REVERSAL


Pigs In A Poke

04/08/05 08:57:19 AM
by David Penn

A month-long negative stochastic divergence in May bellies suggests an April correction.

Security:   PBK5
Position:   N/A

For many in the nontrading world, the idea of trading pork bellies was immortalized by the look that Eddie Murphy gave audiences during that scene in the movie "Trading Places" when the stuffy Duke brothers were trying to explain to him how bellies are bought and sold at the Merc.

Of course, even better than that was Eddie Murphy's theory about relationship between breakfast bacon, "GI Joe with the Kung Fu grip," and the Christmas holidays--a hypothesis as funny as it was, in the movie at least, profitable.


Since April, however, Eddie's bellies have been under a bit of pressure. After bottoming in late January--along with the stock market, by the way--May bellies surged higher over the next six weeks, rallying from a low of 86 cents to as much as 98 cents by the end of March.

Figure 1: Pork bellies. Given the sharp correction in early March, traders should not be surprised if the month-long stochastic divergence leads to sideways prices in April, rather than dramatically lower ones.
Graphic provided by: Prophet Financial, Inc.
 
The Cassandra of pork bellies' most recent correction was a month-long negative stochastic divergence. Compare the price highs in pork bellies early in March and the higher highs late in the month, with the stochastic high in early March and the lower high in the stochastic late in the month.

In some ways, this is a close call insofar as the levels of the stochastic appear to be virtually equal. Consulting an eSignal chart that provides specific values for the indicators confirmed the lower high in the late March stochastic. Nevertheless, as I suggested in a recent Traders.com Advantage article ("Another Low, Another Punk Divergence," April 4, 2005), traders and analysts should decide for themselves just how much of a divergence they need in order to feel comfortable about anticipating reversals in trends.


When on March 30, the moving average convergence/divergence histogram (MACDH) reversed to the downside following the completed negative divergence, the sell point was set. "Completed" in this context means evidence that the stochastic has actually turned down from the second lower peak--not just suspicion that it had topped. Sometimes that will mean waiting for the second histogram bar after the reversal, but better to have the divergence appear than to merely assume that it will.

This approach, incidentally, would have created a sell entry point at 95.30, which would have been filled on April 4. The close of April 4 was nearly a penny lower, and the trade would be a profitable one as of this writing.

There is something else about divergences that I've pointed out that might also be worth recalling here. Even when a negative divergence, for example, is correctly anticipated, traders should not assume that a tradable move to the downside is in the bag. Sometimes, the negative divergence accompanies a sideways correction, even a sideways correction that shortly leads to higher prices.


That's not to say that negative divergences aren't tradable -- it's simply that traders should be prepared if the correction leaves the market with only a black eye or two instead of a knockout blow to the temple.

I think that might be important here because of the support that May bellies could find at the 92-cent level. This level is where bellies first met resistance on the way up in earliest March, and again in mid-March before breaking out on overwhelming volume. The presence of the 50-day exponential moving average (EMA) between 93 and 92 cents also suggests that support might exist here.

In such a scenario, a bounce back toward the 98-cent level could be the first part of pork bellies' run back into the triple digits later in April.




David Penn

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

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