From the August 01, 2009 issue of Futures Magazine • Subscribe!

A cumulative solution to an age-old problem

CTs PRICE DIVERGENCE

When watching CTs and futures prices together, there is a relationship that the day-trader can exploit. It is referred to as a CTs price divergence. Divergence refers to a discrepancy from normal market behavior that may create a trading opportunity. In the case of a CTs price divergence, there is a discrepancy between NYSE ticks and an E-mini futures price. As before, a picture is worth a thousand words.

Referring to “Break from the norm” (right), the CTs’ chart from March 9, 2009, we see an equivocally bearish day in progress, and then between 10:15 and 11:15 a.m. (Pacific time) a CTs’ price
divergence occurs:

• CTs are flat; and

• ES price rises nine points from 676 to 685.

This is highlighted with a rectangle surrounding the flat CTs period and a trendline under the ES price rise. The divergence is not short-term by intraday standards, lasting more than 30 minutes.

The divergence points to one of two possible market conditions: We are in the midst of a reversal, or the ES price rise is divergent from underlying stock market activity and cannot be supported.

Market reversals are typically accompanied with a clear change in the CTs’ orientation (the CTs’ histogram bias changes, for example), so it’s determined that the first possibility is not accurate. We appear to be in the midst of a CTs’ price divergence, which represents a trading opportunity.

An obvious question probably presents itself: How can such a divergence even be possible, because there never are wide fluctuations between the cash and futures markets? The answer is that the ES price is not divergent from its underlying index value but from the recent sum of the broader NYSE ticks. This discrepancy cannot continue for long. Referring again to the March 9 chart, because the CTs have remained equivocally bearish, a short position is preferred. A short entry on retracement the previous 682-684 support area (previous support has become resistance) makes for a successful trade.

You can imagine an indicator that compares CTs and E-mini futures price action to give signals based on a CTs’ price divergence. An early attempt at such an indicator is shown in the last chart from March 30. The large dot (circled) shows a 0.67% swing retracement in price. The enclosed dark dot identifies a concurrent divergent CTs’ reading.

CTs help answer the trend question, and are an important tool to help stay on the right side of the market. Significantly, CTs also tell us how not to trade — they help keep the trader from executing against a strong trend. The trader should not be positioned on the wrong side of unequivocal CT. Equivocal CTs will indicate that market rotation is expected and we might look at key price levels to set limit orders. Equivocal CTs also indicate it is unlikely we will see an extraordinarily strong trend develop and profit targets can be adjusted accordingly.

For 20 years Michael Gutmann was a software engineer and manager at Intel Corp. He is the co-author of 10 patents in areas of video conferencing and computer architecture technology. A commodity trading advisor, he trades his system daily. His recent book is “The Very Latest E-Mini Trading.” Contact him at mjg@vgxcapital.com

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