How To Use Divergences As Leading Indicators
Many technical traders are often surprised when the indexes or stocks appear to suddenly reverse or collapse in price or value. Frequently technical traders have geared up with the mindset that the market is going to continue running with speculation, when it turns down with no apparent technical pattern.
The problem of being caught in a downdraft is common among technical traders who rely too heavily on price and time indicators and do not evaluated quantity indicators sufficiently. In the modern electronic market place where over 80% of all orders are fully automated, using only price and time based indicators has become hazardous to a trader’s profitability and consistency.
Nowadays with the institutions using many variables of specialized orders that control price, volume is even more critical to use. Price no longer is the most important indicator. Price, Quantity, and Time indicators offer the most reliable, consistent, and leading indication of how price is likely to behave in the near term for short term trades.
See chart example of the Dow Jones Industrial Average (INDX:INDU) with three different indicators below including Volume Bars in the first chart window, Accum/Dist in the second chart window, and MFI in the bottom chart window for indicator comparison viewing.
Negative Divergence between the Dow value and the MFI indicator is a clear warning. This combined with the Accum/Dist indicator also shows that a negative divergence between the Dow value is evident. The Volume Bars are also diverging from the Dow value as the stock rises, see that the volume average is declining.
Each and all of these Quantity/Volume indicators lead warning well ahead of the Dow collapse that the run was weakening, and a risk of a short term topping action was increasing exponentially.
When a technical trader incorporates negative divergence analysis indicators based on Quantity/Volume as well as Price indicators, it provides excellent early signals that warn a run is unsustainable. These indicators are highly reliable for index, ETF, individual stock, and e-mini analysis and are useful for all short term trading styles.