Trading Alchemy Read About Divergence

Divergence

The Alchemy Divergence Indicators were developed in response to a void left in the standard set of indicators provided with Tradestation. The Alchemy Divergence Indicators provide an alert and pop-up text when a divergent condition exists between price and the selected indicator. You can select divergence between price and RSI, MACD, Stochastics or Tick. You may select any one indicator or a combination of any of the four indicators.

Unlike the standard set of TradeStation divergence indicators, the Trading Alchemy Divergence Indicators do not wait for a pivot to occur in price action before indicating a divergent condition. This means that with the Alchemy Divergence Indicator you will receive a divergence indication much quicker than the standard TradeStation divergence indicator. This allows you to get a step on making top or bottom formation decisions and allows you to enter your trading orders much sooner.

What is divergence?

Divergence occurs when the indicator ( RSI, MACD, Stochastics or Tick) is giving you an indication as to direction that is different from the direction that price is moving. For example, price is heading higher and the indicator is heading lower. Divergence occurs when the higher price is not confirmed by a higher indicator reading.

Types of divergence:

Bullish Divergence - occurs when price is making a lower low and the indicator is making a higher low, failing to move to a new low with price. This is a great sign of a potential bottom and many traders look deeper for confirmation of a buy signal when bullish divergence occurs. Often times, you will see bullish divergence correspond with the low of the day.

Bearish Divergence – occurs when price is making a higher high and the indicator is making a lower high, failing to move to a new high with price. This is a great sign of a potential top and many traders look deeper for confirmation of a sell signal when bearish divergence occurs. Often times, you will see bearish divergence correspond with the high of the day.

Bullish and bearish divergence is a great tool for the intra-day trader. However, spotting actual divergence with price and the indicator can be a very tedious and inconsistent task for most traders. With the Alchemy Divergence Indicators all the difficult and tedious measuring are done for you in a very visual and consistent manner. This allows the trader to concentrate on possible trade set-ups and trade confirmation signals.

A Detailed Explanation of the Indicators Used for Alchemy Divergence:

Commodity Channel Index – CCI

The Commodity Channel Index (CCI), which is best used with contracts that display cyclical or seasonal characteristics, is formulated to detect the beginning and ending of these cycles by incorporating a moving average together with a divisor, which reflects both possible and actual trading ranges. The final index measures the deviation from normal, which indicates major changes in market trend. Many traders use the CCI as an overbought/oversold indicator with 100 or greater indicating that the market is overbought, and -100 or less that the market is oversold. The Alchemy CCI Divergence Indicator is designed to display divergence in these overbought and oversold zones.

The Alchemy CCI Divergence Indicator is used for counter trend trades. It displays bullish divergence when price makes a lower low while the CCI makes a higher low and it displays bearish divergence when price makes a higher high while the CCI makes a lower high. These CCI divergences can be used in conjunction with CCI overbought/oversold line crosses and CCI trendline breaks for entries.

Relative Strength Index – RSI

The RSI is a momentum indicator which measures price relative to itself. It is relative to its past performance and is front weighted. Therefore, it gives an excellent velocity reading in comparison to other indicators. The RSI is less affected by sharp rises or drops in price performance. Thus, it filters out some of the "noise" in an instruments trading activity.

The RSI tends to treat price as a rubber band. The rubber band can be stretched just so far. After a certain point the rubber band is forced to contract. The RSI is a momentum indicator which usually turns ahead of price and lends itself well to trendlines, support and resistance levels and divergence.

One of the most important aspects of the RSI is to look for divergence between price action and RSI readings. Upwardly sloping price and downward sloping RSI should be taken as a warning that price is about to break down. The reverse is true for downward sloping price and upward sloping RSI. This usually indicates that price is about to break out of a decline.

Stochastics

The Stochastics oscillator compares where price has closed relative to its price range over a specifically identified period of time. The theory is that in an upwardly trending market, prices tend to close near their high; and during a downward trending market, prices tend to close near their low. Further, as an upward trend matures, price tends to close further away from it’s high; and as a downward trend matures, price tends to close away from it’s low.

The Stochastics indicator attempts to determine when price starts to cluster around it’s low for an uptrending market and around it’s high in a downtrending market. These are the conditions which indicate a possible trend reversal is about to occur.

The Stochastics indicator is plotted as two lines. They are the %D line and the %K line. The % D line is more important than the %K line. The Stochastic is plotted on a chart with values ranging from 0 to 100. Readings above 80 are considered strong and indicate that price is closing near it's high. Readings below 20 are considered strong and indicate that price is closing near it’s low.

Ordinarily, the %K line will change direction before the %D line. However, when the %D line changes direction prior to the %K line, a slow and steady reversal is usually indicated. When both lines change direction, and the faster %K line subsequently changes direction to retest a crossing of the %D line, but does not cross it, this is a good confirmation of the stability of the prior reversal in price. Many times when the %K or %D lines begin to flatten out, this is an indication that the trend will reverse during the next trading range.

Quite often, divergence sets up on the Stochastics chart. That is, price may be making higher highs, but the Stochastic oscillator is making lower lows. Or conversely, price may be making lower highs, and the Stochastic oscillator is making higher highs. In either case, the indicator usually is demonstrating a change in price before price itself begins to change trend. In addition, the Alchemy Stochastics Divergence Indicator uses a proprietary Trading Alchemy formula which was specifically designed for detecting divergence. Using standard stochastics for spotting divergence can lead to many false signals and trading frustration. The Alchemy Stochastics Divergence Indicator was designed to filter out many of the false signals allowing the trader to use the signals with much more confidence.

Moving Average Convergence Divergence (MACD)

The MACD is an oscillator which is derived by dividing one moving average by another. The moving averages are usually exponentially weighted, thus giving more weight to the most recent price action. MACD is plotted on a chart with a horizontal equilibrium line. The equilibrium line is important. When the two moving averages cross below the equilibrium line, it means that the shorter exponential moving average (EMA) is at a value less than the longer EMA. This would be a bearish signal. When the EMA’s are above the equilibrium line, it means that the shorter EMA has a value greater than the longer EMA. This is a bullish signal.

The Moving Average Convergence Divergence indicator name is derived from the fact that the shorter EMA is continually converging toward and diverging away from the longer EMA. MACD’s can be used for an infinite number of time periods. Divergence can occur using the MACD indicator and many traders use the MACD to detect divergence.

TICK

The TICK, also known as the NYSE cumulative tick index, is a measure of the number of NYSE stocks that at any moment are trading on an up tick if positive or on a down tick if negative. Although the TICK is without question a lagging indicator, it is still helpful to the trader in many ways. First, if you are currently in an established position in the market, the TICK is an excellent confirmation as to whether or not you have the right side of the market. For example, if you are long the market with a position, it is very helpful to watch the TICK to see if it is improving from a lower-level and trending up to a higher level. That will confirm that the cash market is indeed moving along with the futures which will give you greater confidence to maintain your position.

When the TICK reaches extreme levels it is a good indication that the trend may be close to running out of steam. Of course, extreme levels vary. The TICK can also be used by traders to assist in confirming reversal chart formations. If the TICK is at an extreme level and then begins to reverse and head in the opposite direction, this could be a great confirmation, along with other chart patterns, that a reversal is occurring.

The TICK can also be used as an excellent divergence indicator and will assist the trader in identifying major turning points in the day.