In the stock market, anything can happen in the short term time frame. A trader know this fully well. So, in order to adapt to the unpredictable price swings, a trader needs to rely on strong signals to determine the most ideal point of entry and exit.
Technical market signals are basically specific chart patterns and combinations that tell you the ongoing condition of supply and demand. Bullish signals point to increased volume in buying. Bearish signals point to increased volume in selling. And an equilibrium between the two points to a consolidation.
Generally, the stronger the signal is, the higher the chance that the price will move in a certain way. As such, a trader constantly monitors and interprets the chart in search of these technical signals. Since there are a multitude of market signals to discuss, we'll stick first to one of the strongest out there, which are Divergences.
What is a Divergence?
A Divergence happens when the stock price is moving in the opposite direction of an oscillator (usually the RSI). This means that the strength in buying or selling is weakening and the price will likely shift in trend.
Types of Divergences
There are two types of divergences. A Bullish Divergence and Bearish Divergence. When used in conjunction with other technical signals, it becomes an accurate tool to enter and exit stocks especially in the short term time frame.
1. Bullish Divergence
A Bullish Divergence is illustrated in the chart when the RSI starts to make a new higher low while the price of the stock is establishing a new lower low. This signifies weakening selling pressure that might result to an uptrend shift.
2. Bearish Divergence
A Bearish Divergence is illustrated in the chart when the RSI starts to make a new lower high while the price of the stock is establishing a new higher high. This signifies weakening buying pressure that might result to a downtrend shift.
Bullish Divergence as an Entry Signal
When looking for a potential play, a good high conviction setup to watch out for is a Bullish Divergence. This usually happens to down trending stocks that have recently been experiencing a spike up in institutional buying. This can be observed when the RSI no longer aligns with the downtrend in price and instead, starts to inch upward.
Here is a basic template to follow:
Monitor for a clear bullish divergence between the price and the RSI.
Wait for the initial bounce from the newly formed lower low candle.
Enter the position as soon as a spike in buying volume happens intra day.
Be prepared for initial selloffs as the price tries to breakout from it's dynamic resistance (usually the EMA9 line or MA20 line).
Bearish Divergence as a Sell Signal
When you are holding to a stock that has rallied substantially, a good time to sell in strength is when it forms a Bearish Divergence pattern. This happens when the price creates a higher high while the RSI is forming lower highs. This suggests weakness in momentum and may mean that sellers are already overpowering the buyers.
Here is a basic template to follow:
Check your current stock positions that have spiked considerably.
If you are holding it for a short term play, constantly observe for any signs of a bearish divergence when the price starts to reach new highs.
When the RSI fails to move alongside the advance in price, check if any strong price rejection happens.
Sell when the price has been rejected from a higher high candle while the RSI is forming lower highs.
Bearish divergences are validated when price breaks down further below EMA9 and MA20 with increasing volume.
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