Divergences 1, Candlesticks 0

10/07/05 02:24:17 PM

by David Penn

A negative stochastic divergence compels the emini S&P 500 lower in spite of signs of buying strength.

Security: ESZ5
Position: N/A

I'm being a bit facetious in awarding points to stochastic divergences at the expense of candlestick analysis. But that scorecard accurately reflects my sentiments from yesterday as I contemplated the ability of the December emini Standard & Poor's 500 contract to close below the 1200 level in intraday trading.

As Figure 1 shows, support at the 1200 level on Thursday, October 6 was significant. By the time volume picked up in the early morning hours (here on the Left Coast, that is), support at 1200 was increasingly apparent in the form of the long lower shadows or tails that reached down to barely touch the 1200 level before buyers bid the ESZ5 back up higher. See Figure 1.

FIGURE 1: DECEMBER EMINI S&P 500. While buyers showed an ability to keep prices above 1200 in the early morning hours, the negative stochastic divergence that developed over that period suggested that it might be only a matter of time before the buyers would give up and the sellers overwhelm them.

Graphic provided by: eSignal.

Betting against a market that is showing that kind of behavior at a fairly obvious support level is something I've never felt especially comfortable doing. Sure, the more that support is tested, the more likely it is to eventually be broken. But tests that close closer to the support level, it seems to me, are more powerful than tests that repeatedly involve buyers able to bid prices away from support. If anything, support at 1200 seemed to be as much affirmed as rendered suspect during those early morning hours.

Nevertheless, the appearance of the negative stochastic divergence suggests that any upside that might result from sound support at 1200 might be limited--or even nonexistent. There have been plenty of instances in which negative divergences have not resulted in appreciably lower prices, as I have written about repeatedly in Traders.com Advantage. Yet in the context of a downwardly trending market (on a daily basis), I was willing to give more credence to a negative stochastic divergence that was appearing, as this one was, near the top of a bounce in that downwardly biased market.

Helpfully (and again to underscore the facetiousness of my jibe at candlesticks), the second higher high in the ESZ5 was accompanied by a shooting star or inverted hammer candlestick. Again, it would be possible to say that between the relative bullishness of the support-testing candlesticks previous and the relative bearishness of the inverted hammer, the candlestick analysis would be neutral. In that case, the negative stochastic divergence could be the deciding factor.

Using the confirmation rule I discussed months ago in Working-Money.com ("Confirming Divergences," December 22, 2004), I spotted a selling entry level just below the low of the initial stochastic high candlestick. That candlestick would be the small, doji-like candlestick of 5:45-6:00 am (Pacific time) and the low of that stick was 1203-3/4. Shaving 1/2 off of that low, a move in the December emini S&P 500 below 1203-1/4 would confirm the negative stochastic divergence and signal further downside. In addition, ESZ5 should not trade above the high of the inverted hammer at 1207. Total risk? 3-3/4 points or $187.50.

The short entry would have been filled immediately after the inverted hammer/shooting star. There would have been a brief visit to the house of pain as the ESZ5 moved as high as 1206-1/2 (a loss of 3-3/4 points or about $162.50). But the rewards for staying with the position would have been rich indeed, as the "house of pain" was merely 15 minutes later gentrified into a veritable palace as the December emini S&P fell to 1201 and proceeded to move even lower of the course of the next hour and a half. By the time the market began hinting at a bottom with a hammer-like reversal candlestick between 12:30 and 1 pm (again, PT), the short trader was ahead of the game by some 12 points or approximately $600.

David Penn

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

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