Why Investors Should Be Careful Using Market Divergence Signals

Nearly all technical analysts of stocks and other securities make use of technical indicators to help them make trading and investing decisions.

Technical indicators are created by applying some mathematical calculation or function to the price and volume data of an underlying security. Technical analysts frequently compare the behavior and structure of indicators with the actual price and volume information. Today, I’d like to focus on market divergence signals – what are they, why they don’t always work, and some guidelines for how we can use them as active investors in today’s market.

Divergence Defined

Comparing the two lines gives rise to the concept of “divergence” – a situation where the price of a security is moving in one direction and the indicator in the other.

A significant market divergence signal is regarded as a reliable sign of a pending price trend change. For example, if the price of a security is trending down, while an indicator has started moving higher, technical analysts will conclude that the price of the security is about to reverse and start moving higher as well.

Pitfalls of Divergence

Unfortunately, market divergence indicators happen to be the most overused and poorly understood technical concept, leading many traders to make wrong decisions about the status of the market or the likely direction of a security.

In the last 3-4 years, instances of “negative divergence” have repeatedly been cited as the reason for a pending stock market top by many bearishly inclined analysts.

Conclusion

Here are some high-level guidelines for how traders should use indicators and approach market divergence:

1. Only Price Matters – Nearly all indicators are derived from price and volume information. Your trading or investing decisions should always be driven by what the price is doing, while you can use an indicator to confirm or support the decision. It should never be the other way around.
2. Know Your Indicator – If you are going to commit capital based on any indicator (even in the supporting role) make sure you understand how it is calculated and how it behaves under all market conditions. Most importantly, make sure you understand its limitations and conditions under which its reliability is suspect.
3. No Edge In Divergence –  Price-indicator divergences frequently produce false signals and should always be taken with a big grain of salt, especially in trending markets.

How to perform a multiple time frame analysis

Most traders pick their one time-frame and then almost never leave it. Or they just leave their time-frame to go down to lower time-frames to find more trading opportunities – which basically means they are recklessly hunting for signals on time-frames they shouldn’t be on.

The professional trader knows that the only way to approach trading is with the top-down approach and you’ll shortly see why.

Top-down vs. bottom-up – the biggest mistake of multiple time frame analysis

The biggest mistake traders make is that they typically start their analysis on the lowest of their time-frames and then work their way up to the higher time-frames.

Starting your analysis on your execution time-frame where you place your trades creates a very narrow and one-dimensional view and it misses the point of the multiple time frame analysis. Traders just adopt a specific market direction or opinion on their lower time-frames and are then just looking for ways to confirm their opinion. The top-down approach is a much more objective way of doing your analysis because you start with a broader view and then work your way down.

! Tip: Doing a multiple time frame analysis while you are in a trade can be a real challenge because of the trade-attachment. Once in a trade, the supposedly objective performance then turns into justifying your trade. Especially when you are in a losing trade, you have to be very aware of how you are doing your analysis; avoid justifying a (losing) trade based on the “bigger-picture” market view.

Multiple time frame analysis helps you stay open-minded

Obviously, the daily time-frame is less important if you are trading off the 1 hour time-frame. However, a trader who never leaves his execution time-frame has a very narrow view on the market and cannot put things into the right context.

Every trader, regardless of his main time-frame, should has to start his trading day looking at the higher time-frames to be able to put things into the right perspective. But looking is not enough because once you arrive at your lower time-frame and are in the midst of your trading session, you will have forgotten what you saw on the higher time-frames. There are two ways to deal with this problem:

1) Get a physical notepad

On your trading desk, place a physical notepad and for every market you trade, write down what you saw. We also offer a free trading plan template that can help you stay organized.

2) Annotate your charts

All charting platforms offer text objects and you can use them to directly write on your charts. It is also advisable to mark the areas on your chart that are your areas of interest. This way you are less likely to jump the gun and enter prematurely.

Multiple time frame analysis – step by step

When it comes to actually performing your multiple time frame analysis, you don’t have to get too fancy. But knowing what to do and how to approach it can help you build a time effective routine that guides you through your trading sessions.

Weekly / Monthly  – Where are we?

If you mainly use the 4 hour or 1 hour time-frame to execute your trades, you don’t have to spend too much time here. Basically, you just want to get a feeling for the overall market direction and if there are any major price levels ahead. Especially long-term support and resistance or weekly or annual highs and lows should be marked on your charts

Daily – Strategic time-frame

On the daily time-frame, you have to spend a bit more time on. Here you analyze the potential market direction for the week ahead and also determine potential trade areas. Again, draw your support and resistance lines and mark swing highs and lows – even if you don’t use them in your trading, it is worth having them on your charts because they are so commonly used.

4H (1H) – Execution

Assuming that the 4 hour is your execution time-frame, this is where you map out your trades and specific trade scenarios. Take the levels and ideas you came up with on the daily time-frame and translate them into actionable trade scenarios on the 4 hour time-frame.

Ask yourself where you would like to see price going, what has to happen before you enter a trade and what are the signals you are still missing.

Staying open minded – 2 tips

Always create long and short trade scenarios when doing your multiple time frame analysis. This will keep you open-minded and it avoids one-dimensional thinking. A trader who is only looking for short trades, will blank out all signals that point to a long trade. Or, a trader on a long trade will miss the signals that could signal a reversal.

Furthermore, separate your charting from your actual trading platform. If you can see your open orders on your screens during your analysis, you are much more likely to be biased during the analysis

The First 12 Questions for a Trader to Answer

1. What time frame will you be trading in? This establishes your needed screen time.
2. What will be your specific entry signals? What price action or technical indicators will get you into a trade?
3. What will be your specific exit signals after entry? Stop loss, trailing stop, or price target.
4. How much are you willing to lose per trade?
5. What risk/reward ratio are you looking for in your trading?
6. What win percentage do you need to be profitable with your risk/reward ratio?
7. What are the probabilities of a draw down with your win/loss probabilities and risk per trade?
8. How many trades a month do you need ideally to hit your annual return goals?
9. How much will your commission costs for your trading activity level be as a percentage of your account monthly?
10. Do you have a trading system?
11. Do you have a complete trading plan?
12. Can you follow your plan and system with discipline?