A Technical Signal Giving You Consistent Profits

| October 14, 2009 | 0 Comments

Many of you may have heard this excerpt from “The Road Not Taken”:

“… Two roads diverged in a wood, and I — I took the one less traveled by, And that has made all the difference.”

It was written by Robert Frost.  He was a great poet and playwright from the early 1900s.

I’m sure Mr. Frost didn’t intend for his epic poem to have anything to do with trading.  However, his poem brings up an interesting trading concept.

This concept is known as momentum divergence (two signals diverging).

It can guide your trading to new heights…

Divergence works with momentum indicators.  Momentum indicators are tools traders use to measure overbought or oversold levels.  One popular momentum indicator is the RSI.  (There are others like MACD and Stochastics, but we’ll discuss those in a future article.)

RSI is short for Relative Strength Index.  It refers to the internal strength of a stock’s price relative to its historical price performance measured over a period of time.  More simply, it’s measuring how overbought or oversold a stock is.

Here’s what you really need to know.  A reading of 70 and above is overbought.  A measure of 30 or below is considered oversold.

Some charting programs let you adjust the time setting.  A 14-day period is common for RSI.  That’s what we’ll use here.

Now, don’t let the technical mumbo jumbo scare you.  RSI is a simple concept to grasp.

Potash (POT) is a leading producer of liquid phosphate fertilizers in North America.  Their main customers are farmers.  In 2008, they posted $9.4 billion of revenue.

POT was a darling stock at the start of 2008.  Commodities were on a run and demand for fertilizer was through the roof.

If you had bought the stock at any time in the first quarter of the year, you’d be seeing some great profits.  Of course, you don’t want to risk giving up all your profits on such a nice trade!

Look at the price chart.  The stock ran from a low of $120 and made a high of $214 in April.  It went on to make a higher high of $240 in June.  Things are looking strong for POT.

But let’s look a little closer…

Take a look at the RSI indicator at the top of the chart.  Notice how the RSI reading made a high in April right along with the stock.

Now look at the new high in June.

See how the RSI didn’t make a new high in June while the stock did (the blue arrows).  This tells us the upside momentum in POT is weakening.  This is called a momentum divergence.  It’s when the momentum indicator (in this case RSI) doesn’t confirm the upward price movement of a stock.

It’s an early warning sign.

If you see this setup in any of your stocks, be ready to sell!

By following this simple indicator, you could have saved yourself thousands of dollars of lost profits.

There are other uses for momentum divergence.  Not only will this technical signal guide you to a good exit point, it’s also very useful for telling you when not to buy.

Think back to our POT example.  If you saw this upward momentum divergence, you’d think twice before buying stock at that point.  Odds are a selloff is close at hand.

To be clear, using a momentum divergence signal doesn’t allow you to pick precise tops and bottoms in the market.  However, it’s a great guide to prepare you to take action.

Use it as an early warning signal to exit profitable trades.  Give it a quick look before establishing a new position.

By incorporating technical signals like these into your trading, you’ll have an edge over other less experienced traders.

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Category: Technical Analysis

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