While
using divergences is a great tool to have in your trading toolbox, there are
times when you might enter too early because you didn't wait for more
confirmation. Below are a couple of tricks that you can make use of so that you
have more confirmation that the divergence will work out in your favor.
Wait for a crossover
This
ain't so much a trick as it is a rule. Just wait for a crossover of the
momentum indicator. This would indicate a potential shift in momentum from
buying to selling or vice versa. The main reasoning behind this is that you are
waiting for top or bottom and these can't be formed unless a crossover is made!
In the
chart above, the pair showed lower highs while the stochastic already made
higher highs. Now that's a bearish divergence there and it sure is tempting to
short right away.
But, you
know what they say, patience is a virtue. It'd be better to wait for the
stochastic to make a downward crossover as confirmation that the pair is indeed
headed down.
A couple
of candles later, the stochastic did make that crossover. Playing that bearish
divergence would've been pip-tastic!
What's
the main point here? Just be patient! Don't try to jump the gun because you
don't quite know when momentum will shift! If you aren't patient, you might
just get burned as one side keeps dominating!
Moving out of overbought / oversold
Another
trick would be to wait for momentum highs and lows to hit overbought and
oversold conditions, and wait for the indicator to move out of these
conditions.
The
reason for doing this is similar to that of waiting for a crossover - you
really don't have any idea when momentum will begin to shift.
Let's say
you're looking at a chart and you notice that the stochastic has formed a new
low while price hasn't.
You may
think that it's time to buy because the indicator is showing oversold
conditions and divergence has formed. However, selling pressure may remain
strong and price continues to fall and make a new low.
You would
have been pretty bummed out as trend didn't continue. In fact, a new downtrend
is probably in place as the pair is now forming lower highs. And if you were
stubborn, you might have missed out on this down move too.
If you
had waited patiently for more confirmation that the divergence had formed, then
you could have avoided losing and realized that a new trend was developing.
Draw trend lines on the momentum indicators themselves
This
might sound a little ridiculous since you would normally draw trend lines only
on price action. But this is a nifty lil' trick that we wanna share with you.
After all, it doesn't hurt to have another weapon in the holster right? You
never know when you might use it!
This
trick can be particularly useful especially when looking for reversals or
breaks from a trend. When you see that price is respecting a trend line, try
drawing a similar trend line on your indicator.
You may
notice that the indicator will also respect the trend line. If you see both
price action and the momentum indicator break their respective trend lines, it
could signal a shift in power from buyers to sellers (or vice versa) and that
the trend could be changing. Oh yeah! Break it down like a Michael Jackson
video!
