Chart Chat - Divergences

1. The best indicator of where price is likely to go (near-term) is the price chart itself. However, there are hundreds of indicators created to help solve this problem. Yet, all we have to work with on charts is:
   • Price (Open, High, Low, Close)
   • Volume
   • Time

2. All indicators are derived from these three factors and their many combinations. The goal is to see into the future, to determine where the price will go! Forget it… We can never know with certainty where the price will go. We can improve the odds, increase the likelihood of our “guess-success,” and that can provide the “edge” needed for success in the market. Proper use of indicators can be very rewarding.

3. The price chart can send subtle messages and indicators can help understand those messages. But, of paramount importance:
   Most price charts tell us nothing most of the time!

4. That said, when messages are sent, they are worth solid gold. The most rewarding messages are called “divergences,” where the indicator can contradict the price pattern. Good indicators have that ability. Two examples are shown here, analyzing picks made on 12/05/03. The first ticker, WMGI, is shown on that Friday on the following chart, with the closing price of $28.28. Bollinger Bands are attached around a Candlestick price chart with Wilder’s Relative Strength Indicator in the second window. RSI is a good indicator on its own, but we’ve added a Rate of Change (ROC) measure to the same window. This ROC indicator measure how fast the RSI is changing, an important factor in the dynamics of market action. (See pages 119, 120 and 127 in our book Provident Investing for an explanation of these indicators)
   
   Fig. 1 WMGI price pattern showing Price/ROC divergence.

5. Notice the two dashed lines, the upper connecting successive “highs” of the price chart, the lower connecting successive “highs” of the ROC indicator. This is a divergence. Indicators usually follow the price pattern. The subtle difference is seen by the slopes of each dashed line. When the price diverges from an indicator, the indicator usually prevails. The following chart shows where the price went following 12/5/03.
   
   Fig. 2 WMGI price pattern since 12/05/03.

6. While the price chart since the pick is not dramatically higher, it has formed a classic W (double-bottom) pattern with volume support that is usually a winner. Watch this price chart in the coming days. The next chart uses the same ROC indicator to project a divergence on another pick made on 12/05/03. This time the divergence is subtle but unmistakable. The dashed line under the successive ROC lows is
   
   Fig. 3 CYTO price pattern showing Price/ROC divergence.
   
   Fig. 4 CYTO price pattern since 12/05/03.

7. Divergences between the price chart and indicators are powerful aids as we seek the “edge” necessary to succeed as traders. We will add this corner to the Pro-fundity page, highlighting examples to illustrate important charting principles. This material is created as we do post-mortem analysis on picks made each week. Our greatest lessons are learned studying pick performance, what went right, what went wrong.