Watching The Divergences: Picking A Short Point In The December T-Note Rally

09/26/07 09:38:30 AM

by David Penn

Waiting for a confirming close can make all the difference between getting whipsawed and getting rewarded in the market.

Security: TYZ7
Position: N/A

For years I struggled to figure out how best to enter a market after a given buy or sell signal. For the most part, I looked at the range of the signal session as a key, sometimes using the average true range indicator, but other times simply adding or subtracting some fraction of that signal session's range to the high or low of that session as a target for a long or short trade.

At this point, I rely on something much simpler: a follow-through, confirming close beyond the high or low of the signal session. Whether a market's confirming close is only half a point beyond the high or low or five points, that kind of follow-through, it seems to me, is all that is required to show that a market is actually capable of moving in the desired direction (as opposed to simply no longer moving in the old direction).

Consider the example of December Treasury notes (TYZ7) (Figure 1). The market for these notes had been in a strong bull trend. This bullishness was made clear when the moving average convergence/divergence (MACD) histogram peak in late July exceeded that of late June. Increasing MACD histogram peaks are one signal of a market that is gaining in momentum to the upside. Traders of T-notes in late July knew that, however much the market might correct in the meanwhile, the price highs of late July would be exceeded.

As it turned out, they were exceeded within two calendar weeks.

FIGURE 1: 10-YEAR TREASURY NOTE, DECEMBER FUTURES, DAILY. Multiple negative divergences emerged as the market for December T-notes moved higher in the late summer and early autumn of 2007. Yet it was not until a confirmed close in the first half of September that these negative divergence signals produced a tradable move.

Graphic provided by: Prophet Financial, Inc.

But consider the December Treasury note market from the perspective of a doubter looking to fade the rally (as I was in late July, looking at certain candlestick patterns in isolation). The first negative divergence in the MACD histogram was confirmed on August 22 with a mMm pattern. Was that negative divergence a short and a potential end to the T-note rally? No. Why? The market failed to make a follow-through confirming close in the form of a close below the low of August 22.

There was intraday penetration of the August 22nd low of 108.453. On August 23, the market for December T-notes traded as low as 108.1875. However, the close of that session saw the market rally back to 108.8125. Based on that close, the negative divergence pattern should not be traded to the downside.

Bearish traders got another opportunity on August 31, as the MACD histogram developed another negative divergence. But once again the market failed to close below the low of August 31 — meaning no short trade.

The market for December T-notes eventually did throw a bone to the bears with the negative divergence in the first half of September. The mMm pattern within the negative divergence was completed as of the close on September 11, and that divergence was confirmed by a follow-through lower close on September 12 at 110.5781. A day later December T-notes were closing at 110.0156, a gain of more than $500 per contract.

Will this tactic of waiting for the confirming close work in every instance? Of course not. When markets are especially volatile and indecisive, when control of a market is shifting rapidly back and forth between bulls closing the market at or near the highs one day and bears closing the market at or near the lows the next, confirming closes will carry less weight. But more often than not, waiting for a confirming close will provide that much more assurance that the market CAN do what you want it to do as a trader. And in the proper context, that assurance is all that is needed for a sound trade.

David Penn

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

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Watching The Divergences: Picking A Short Point In The December T-Note Rally

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