TRADING SYSTEMS Spotting Trend Reversals Trading Medium-Term Divergences Detect medium-term divergences by using the zero-lagging exponential moving average, support and resistance lines, and trendlines. Up move convergence Condition Expectation Higher bottom Uptrend continuation Higher bottom W hen a stock price and an oscillator move in the same direction it s known as a convergence. When price and oscillator move in opposite directions, it s known as a divergence. In looking at the lows of the oscillator and comparing them with the lows in price, we can define three different situations (see Figure ): When the price and oscillator make higher or equal bottoms, they converge. Until there is no other indication, the most probable price move is a continuation of the uptrend. When the oscillator creates a higher bottom while the price makes a lower bottom, they diverge. This is mostly found at the end of a downtrend, indicating an uptrend reversal. When the oscillator has a lower bottom while the price sets a higher bottom, they diverge. This is mostly found in a price uptrend after a price correction, indicating a continuation of the uptrend. Simply looking at bottoms, we can say that the price is going to move up if there is a divergence between the price and the oscillator or if the price and the oscillator bottoms converge in an uptrend. Looking at the highs of the oscillator and comparing them with highs in price, we can define three other situations (see Figure 2): by Sylvain Vervoort higher-bottom divergence When the price and the oscillator make equal or lower tops, they converge. Until there is no other indication, the most probable price move is a continuation of the downtrend. When the oscillator makes a lower top while price makes a higher top, they diverge. This is mostly found at the end of an uptrend, indicating a downtrend reversal. When the oscillator makes a higher top while price makes a lower top, they diverge. This is usually found in a price downtrend after a price up correction, indicating a continuation of the downtrend. Lower bottom lower-bottom divergence Higher bottom Higher bottom Lower bottom Uptrend reversal Uptrend continuation FIGURE : COMPARING PRICE AND OSCILLATOR BOTTOMS. Here you see the three different scenarios at price and oscillator bottoms. Down move convergence Condition Expectation lower-top divergence higher-top divergence Lower tops Lower tops Higher top Lower top Lower top Higher top Downtrend continuation Downtrend reversal Downtrend continuation FIGURE 2: COMPARING PRICE AND OSCILLATOR TOPS. Here you see three different situations at price and oscillator tops.
WILLIAM L. BROWN
7 3 30 2 0 90 80 30 20 0 390 380 3 3 7 2 30 20 0 390 380 3 3 3 3 330 320 30 300 290 280 2 March April August September October FIGURE 3: UPTREND REVERSAL DIVERGENCE. After the divergence and from point the RSI and the S&P 0 converge at each higher low. FIGURE : UPTREND CONTINUATION DIVERGENCE. Between points and 2 the RSI makes a divergent move, resulting in the continuation of the uptrend. 3 30 March 2 April 3 6 May 00 0 000 FIGURE : DOWNTREND REVERSAL AND CONTINUATION DIVERGENCE. Between and 2 is a divergence in the index and RSI. A lower top in the index and a higher top in RSI between 3 and indicate a continuation of the downtrend. Between and 6 you see a divergence between the index and RSI, which fueled a correction reversal. 2 3 April May June June 6 9 00 000 990 980 9 9 9 9 930 920 90 900 890 880 8 8 8 8 FIGURE 6: VERY SHORT-TERM M AND W PATTERNS. Do not look for convergences and divergences in M and W patterns, as it doesn t do much for forecasting the direction of price moves. Just by looking at the tops, you can say that the price will move down if there is a divergence between the price and the oscillator or if the price and the oscillator tops converge in a downtrend. If the price makes higher bottoms or lower tops, we also consider the move divergent when there are equal bottoms or tops in the oscillator and vice versa. DIVERGENCES AND CONVERGENCES IN ACTION I prefer to use the standard -bar relative strength index (RSI) momentum oscillator, introduced by J. Welles Wilder, to spot divergences with price movement. Let s look at a few examples from the Standard & Poor s 0 to illustrate the previous statements. Figure 3 shows an uptrend reversal at () with a lower low in price but a higher low in the RSI. I am plotting the RSI (left scale) over the index (right scale) for easy comparison. From that point on, the index and the RSI converge with higher lows each time, both in the index value and the RSI. Figure illustrates the continuation of an uptrend. The price is moving all the way up with higher lows each time. However, between () and (2), the RSI makes a divergent move with a lower low compared to the higher low of the index, resulting in the continuation of the uptrend. After (2), price makes a higher top but the RSI does not. Because there is only a very small downward correction, it is a trade we must try to avoid. More about that later. In Figure you see an example with top divergences. There is a trend reversal with a higher top in the index and a lower top in the RSI between () and (2). Next, there is a lower top in the index and a higher top in the RSI between (3) and () indicat-
7 3 October 2 3 November 6 7 December 200 February March FIGURE 7: TRADING MEDIUM-TERM REVERSALS. Here you see how you can apply convergences and divergences between price movement and the RSI to identify medium-term reversals. ing a continuation of the previous downtrend. Between () and (6), there is an uptrend reversal to start the upward correction in the downtrend, with a lower bottom in price and a higher bottom in the RSI. A typical and easy way to recognize short-term signals is the M- or W-shaped pattern in the RSI appearing at tops and bottoms, respectively. It can be the start of a medium-term reversal, but most commonly they are only short-lived. In Figure 6 you can see a number of M-shaped patterns, marked to. After each M pattern, the index makes a small move down. Points and 6 in Figure show two W-shaped patterns. After each W-shaped pattern, the index makes a small move up. But looking for convergences or divergences in the M/W patterns makes no sense. After the M pattern in point, you would expect a bigger downward move by the divergence as a result of the higher top in the index and the lower top in the RSI. WHICH SIGNALS ARE BEST? Now, look at some more complex formations. Trading on every short-term divergence signal is not a good solution, so you need to find out which signals you must take into consideration. In addition to the M/W patterns, buy and sell signals based on divergences between price and an oscillator will show up quite often. The more profitable ones for trading are those that appear during medium-term price reversals. This means you have to keep track of the medium-term trend. For this I use a 20-bar zero-lagging exponential moving average (EMA). If you do not already have this moving average, the MetaStock formula to create this average is shown in sidebar, 20-bar zero-lagging EMA for MetaStock. You can also look at trendlines and support and resistance lines before making any buy or sell decisions. MEDIUM-TERM REVERSALS The daily chart of the S&P 0 in Figure 7 is an example on how to find medium-term reversals looking at price and RSI convergences and divergences. The blue curve is the -bar RSI with left scaling. The red curve is the 20-bar zero-lagging EMA. At the end of October, a new price up move started at. The index reached a temporary top 2 and a first small reaction followed. Between 3 and, there was a divergence comparing bottoms, resulting in the price being pushed up to. Here we see a divergence with a new top in price, but not in the RSI compared with top 2. Does that mean we have to sell here? 8 9 0 2 3 220 20 200 90 80 30 20 0 20-BAR ZERO-LAGGING EMA FOR METASTOCK Period:= Input( What Period?,,00,20); EMA:= Mov(CLOSE,Period,E); EMA2:= Mov(EMA,Period,E); Difference:= EMA - EMA2; ZeroLagEMA:= EMA + Difference; ZeroLagEMA is close to the horizontal support 3. The moving average was still going up, but with less acceleration. Only one day later, price moved up again from a higher bottom at 6 and with a lower bottom in the RSI, a setup to push the price higher. So you would probably still hold the position. As the price and RSI approached point 7, you had the same scenario as in. Once more, you must ask yourself if you have to close the position. At this point, the moving average is still going up. is close to, but remains above, the green medium-term up trendline. The reaction is small and took only two more days; that means do not sell. The story repeats itself again at 9. remains above the short-term up trendline and above the medium-term up trendline. Again, it s not time to sell. However, now there is a divergence between 9 7 and 9 2. It feels like the medium-term up move is coming to an end. A few days later at 0, you see another divergence. You also see an M pattern and the close of the day falls through the shortterm up trendline, which are solid reasons to close the position. Waiting one more day brings additional arguments on whether to close the trade, when the index breaks the last support line and falls through the medium-term up trendline. Now there should be no doubt on whether to sell. Next, the index falls in a convergent move to and turns up. The index closes above the down trendline and the moving average is turning up. This may be the end of the downward correction. If you compare the RSI at this point with the start of the previous up move, you see a divergence between and, with a higher bottom in price and a lower bottom in the RSI, pointing in the direction of a continuation of the previous uptrend. Note the W pattern that has formed. Is it time to open a new long position? At 2 you see a small divergence with the price being pushed up. Then there is a convergent move to 3. is falling through support and the moving average is turning down. These are enough reasons to consider closing the position. But looking more closely at this one-day down move, you can see that index falls exactly on the longer-term up trendline. Because of this, you want to wait at least one more day before making a decision. The index moves further up to. The closing price now falls through the last sharper up trendline. The index made a higher high compared to the previous top at 0, but the RSI makes a lower top. This is most probably the end of this up move, so we close the position. Maybe you prefer to look for a confirmation with the moving average going down and the index falling through the longer-term up trendline. I hope this example clarified how to spot the medium-term divergences by using the zero-lagging EMA, support and resis-
SVAPO PRICE ONLY INDICATOR FOR METASTOCK {calculate heikin ashi closing average hacl and get the input variables} hao:=(ref((o+h+l+c)/,-) + PREV)/2; hac:=((o+h+l+c)/+haopen+max(h,haopen)+ Min(L,haOpen))/; {input SVAPO period} period:= Input( SVAPO period :, 2, 20, 8); {input minimum per thousand price change} cutoff:= Input( Minimum %o price change :,0.0,0,); {Inputs for standard deviation bands} devh:= Input( Standard Deviation High :, 0.,,.); devl:= Input( Standard Deviation Low :, 0.,,.3); stdevper:= Input( Standard Deviation Period :,, 200, 00); {Smooth HaCl closing price} hac:=tema(hacl,period/.6); {MA divisor} vave:=ref(mov(c,period*,s),-); {Basic trend} vtr:=tema(linregslope(c,period),period); {SVAPO result of price only} SVAPO:=Tema(Sum(If(haC>(Ref(haC,-)*(+cutoff/000)) AND Alert(vtr>=Ref(vtr,-),2), C, If(haC<(Ref(haC,-)*(- cutoff/000)) AND Alert(vtr>Ref(vtr,-),2),-C,0)),period)/ (vave+),period); devh*stdev(svapo,stdevper); -devl*stdev(svapo,stdevper); zeroref:=0; zeroref; SVAPO tance lines, and trendlines. Profitable trading is relatively easy if divergences are present, but price can also make bigger moves in a convergent way. So it is important to always keep an eye on trendline breaks or support and resistance breaks and the turning points of the zero-lagging exponential moving average. In addition, always keep a stop-loss to protect your investment. You can use an oscillator like SVAPO (see the November and December 2007 issues for a full explanation) to confirm price turning points. SVAPO uses volume, and since I do not have volume data from the S&P 0, I use a modified price-only version of SVAPO. The adapted SVAPO formula in MetaStock language can be found in sidebar 2, SVAPO price only for MetaStock. And the MetaStock formula for a symmetrical trailing stoploss is displayed in the third sidebar, Trailing stop reversal for MetaStock. TRADING DIVERGENCES The brown curve in Figure 8 is a 2% stop-loss on the indexclosing values. It is symmetrical, so it will switch long and short positions at a 2% trailing loss. The green curve is a -bar RSI. The red curve is a 20-bar zero-lagging exponential moving average. Below the price chart is the adapted version of my 7 3 30 0 2 3 2 2 2 2 230 220 20 200 90 80 August September October November FIGURE 8: TRADING CONVERGENCES. By putting together convergences, trendlines, moving averages, patterns, and stops, you can come up with a very effective trading system. 6 7 SVAPO oscillator without volume. It is a five-bar SVAPO with one per,000 minimum price change, and upper and lower standard deviation lines at. and.3 within a 00-bar lookback period. At point, you see a divergence with a higher index and a lower top in the RSI(). The 20-bar zero-lagging EMA is turning down. The index is falling through the last up trendline. There is an M pattern in the RSI. We also have a divergence in the SVAPO and it turned down from above the upper standard deviation line. This gives more than enough reasons for selling a long position and opening a short one. Opening a short position at means you set an initial stop at the highest index level, the red resistance line. This is because if that level is crossed, it means the uptrend is not finished and you should get out of the trade. Having an initial stop that close means the risk/reward for this trade is quite good. What follows is a convergent move down until 2, where you can spot a number of reasons to close the short position and open a new long position. The closing price moves above the down trendline. The RSI has a W pattern. The moving average is turning around, and what is very important, SVAPO is moving up from below the lower standard deviation line. We now keep an initial stop at the last low. You could again wait for confirmation until 3, with the breaking of a horizontal 0 resistance and the breaking of the stop-loss value. The overall profit would, however, be less. After a rather short convergent move up, the price breaks the up trendline at. The previous top was formed with an M pattern. The index falls through a short-term support line. SVAPO has turned and is moving down from above the upper standard deviation line. All these are enough reasons to close the long position and TRAILING-STOP REVERSAL FOR METASTOCK stop:= Input( Trailing Stop,0,20,7); trail:= If(C=PREV,PREV, If(((Ref(C,-)<PREV) AND (C<PREV)), Min(PREV,C*(+stop/00)), If((Ref(C,-)>PREV) AND (C>PREV), Max(PREV,C*(-stop/00)), If(C>PREV,C*(-stop/00),C*(+stop/00))))); trail
TRADING SYSTEMS open a short position, with an initial stop-loss at the previous top. The next day at, you see more reason to close the long position with the break of the stop-loss. The price moves converge further down until 6, when the last down trendline is broken and SVAPO has turned up from below the lower standard deviation boundary. It is time to take a profit on the short trade and open another long trade. If you do not take this trade here, you must do it, at the latest, when the index breaks the stop-loss at 7. There is a nice profit with the next move up. PUTTING IT TOGETHER Be aware of convergent moves that appear now and then and use trendlines, support and resistance lines, and an indicator like SVAPO to handle your trade if divergences are not showing up. And don t forget to always use an initial stop and a trailing stop. You should always use an indicator like SVAPO, even if divergences are present. It will make it easier to spot mediumterm trend reversals. Good trading! Sylvain Vervoort, living in the Flemish part of Belgium, is a retired electronics engineer studying and has been using technical analysis for more than 30 years. He is an independent trader, writer, publisher, and educator in the arena of technical analysis and options. SUGGESTED READING Mulloy, Patrick [99]. Smoothing Data With Less Lag, Technical Analysis of STOCKS & COMMODITIES, Volume 2: February. Valcu, Dan [200]. Using The Heikin-Ashi Technique, Technical Analysis of STOCKS & COMMODITIES, Volume 22: February. Vervoort, Sylvain [2007]. Trading Trendline Breaks, Technical Analysis of STOCKS & COMMODITIES, Volume 2: July, August, September. [2007]. Short-Term Volume And, Technical Analysis of STOCKS & COMMODITIES, Volume 2: November. [2007]. Short-Term Trading With SVAPO, Technical Analysis of STOCKS & COMMODITIES, Volume 2: December. Wilder, J. Welles [978]. New Concepts In Technical Trading Systems, Trend Research. S&C