Trading divergence and understanding momentum

Momentum plays a key role in assessing trend strength because trends are made up of a series of price swings and it is important to know when a trend is slowing down. Less momentum does not always lead to a reversal, but it does indicate that something is changing and can consolidate or reverse the trend.

Price momentum refers to the direction and magnitude of price. Comparing price swings helps traders gain insight into price momentum.

Define Price Momentum

The magnitude of price momentum is measured by the length of short-term price swings. The beginning and end of each swing are established by structural price pivots that form swing highs and lows. Strong momentum is shown by a steep slope and long price swings. Weak momentum is seen with a shallow slope and short price swing.

The length of the swings in an uptrend can be measured. Longer upswings indicate that the uptrend is showing increased momentum or getting stronger. Shorter upswings indicate weakening momentum and trend strength. Upswings of equal length mean that the momentum remains the same.

Price changes are not always easy to evaluate with the naked eye because the price can be volatile. Momentum indicators are commonly used to smooth the price action and provide a clearer picture. They allow a trader to compare the indicator swings to price swings rather than comparing price to price.

Momentum indicators

Common momentum indicators for measuring price movements include the relative strength index (RSI), stochastics and rate of change (ROC). Figure 2 is an example of how RSI is used to measure momentum. The default setting for RSI is 14. RSI has fixed limits with values ​​ranging from 0 to 100.

There is a similar upswing in RSI for every upswing in price. RSI also swings down when price swings down.

Figure 2: Indicator swings usually follow the direction of price swings (A). Trend lines can be drawn on swing highs (B) and lows (C) to compare the momentum between price and the indicator.

Source: Charles Schwab Strategy Desk

The study of momentum simply looks at whether price and the indicator agree or disagree.

Figure 3: Compare price and indicator to make better trading decisions.

Source: Charles Schwab Strategy Desk

Momentum divergence

Disagreement between the indicator and price is called divergence. This can have significant implications for trade management. The amount of agreement/disagreement is relative, so there can be several patterns that develop in the relationship between price and the indicator. Our discussion here is limited to the basic forms of divergence.

There must be price swings of sufficient strength to make momentum analysis valid. So momentum is useful in active trends, but it is not useful in range conditions in which price swings are limited and variable as shown here in Figure 4.

Figure 4: In range conditions, the indicator does not add to what we see from price alone. Variable pivot highs and lows show range.

Source: Charles Schwab Strategy Desk

Divergence in an uptrend occurs when price makes a higher high but the indicator does not. In a downtrend, divergence occurs when price makes a lower low but the indicator does not. When divergence is spotted, there is a greater likelihood of a price pullback. Figure 5 is an example of divergence and not a reversal, but a change of trend direction to sideways.

Figure 5: Momentum divergence and a pullback. Higher pivot heights (small orange arrows) indicate price support.

Source: Charles Schwab Strategy Desk

Divergence helps a trader recognize a change in price action and react appropriately to it. This tells us that something is changing and therefore the trader needs to make a decision such as tightening the stop loss or taking a profit. Seeing divergence increases profitability by alerting a trader to protect profits.

In the stock of Figure 5, Chesapeake Energy (CHK), shares are pulling back toward the support. This graph in Figure 6 shows that trends do not reverse quickly or even often. We make the best profits when we understand trend momentum and use it at the right time for the right strategy.

Figure 6: Trend continuation. Agreement between price and the indicator gives an entry (small green arrows).

Source: Charles Schwab Strategy Desk

Managing divergence

Divergence is important to trade management. Taking profit or selling a call option were good strategies in Figure 5. The difference between the price and the indicator led to a pullback, then the trend continued.

This is often referred to as a bear trap, where the false signal pulls in shorts and price quickly reverses, if you look at the pivot that makes the price below the lower trendline. The signal to enter appeared when the higher lows in price coincided with the higher lows of the indicator in Figure 6: the small green arrows.

Divergence indicates that something is changing, but it does not mean that the trend will reverse. This indicates that the trader should consider strategy options: hold, sell a covered call, tighten the stop or take partial profits. The glamor of wanting to pick the top or bottom is more about ego than profits. Being consistently profitable involves choosing the right strategy for what price does, not what we think price will do.

Figure 7: Divergence leads to range.

Source: Charles Schwab Strategy Desk

Figure 7 shows a divergence leading to sideways price action. Notice the weakening momentum in moving average convergence divergence (MACD) as price enters a range. This indicates that the trader should consider strategy options. We have a disagreement or divergence when price and the indicator are inconsistent relative to each other. We are not in control of what price will do. We only control our own actions.

Figure 8: Divergence and then reversal of trend.

Source: Charles Schwab Strategy Desk

Sometimes divergence will lead to a trend reversal as shown in Figure 8. The Utilities Select Sector SPDR (XLU) shown in Figure 9 pays a dividend and has options. Understanding trend momentum gives investors a profit advantage because there are three ways to profit here: capital gains, dividends and call premium. This example shows trend continuation after a sideways move, which translates into profit continuation.

Figure 9: Go with the trend when the price and the indicator agree.

Source: Charles Schwab Strategy Desk

The Bottom Line

The most useful way to use a momentum indicator is to know which strategy to use. Price will lead the way, but momentum can signal a time to preserve gains. The skill of a professional trader lies in their ability to implement the correct strategy for price action.