From the February 2013 issue of Futures Magazine • Subscribe!

Channeling trends in stocks

Trading divergences

Divergence occurs when the security’s price makes a new high while the CCI fails to surpass its previous high. Divergences probably are the least common of the three signals, but usually are the most reliable and lead to the biggest moves. There are two types of divergences:

  • A positive divergence occurs when the CCI begins to advance and the security is still in a downtrend and makes a lower reaction low. 
  • A negative divergence forms when the security advances or moves sideways and the CCI declines. The negative divergence in CCI can take the form of either a lower-high or a straight decline. 

Confirmation is necessary for a successful divergence trade. Positive divergence is confirmed with a break above the zero-line or the break of a downtrend line on the price chart. Similarly, negative divergence is confirmed with a break below the zero-line or a break of an uptrend line on the price chart.

“CCI divergence” (below) shows Google Inc. (GOOG) with a 20-day CCI on the daily time frame. On Sept. 7, 2012, Google closed at $712.25 and the CCI at 265.68. After Sept. 7, Google continued its rise and made a high of $774.68 on Oct. 5, but the CCI was at 107.88, showing a significant negative divergence with price making a higher-high and the CCI indicator making a lower-low. Negative divergence demonstrated its value on Oct. 18 when Google broke the price support of $740 and went into a freefall mode after results were declared that fell short of market expectations.

Price moves in trends, and while traditional price chart tools such as trendlines and moving averages can signal important shifts in sentiment, more sophisticated indicators are useful across varying conditions. The CCI is one such tool. It offers multiple ways to analyze price movements, and it works well with confirming indicators, such as trendlines, to forecast major moves.

Bramesh Bhandari trades the Indian stock market and teaches technical analysis. Bramesh can be reached via email at bhandaribrahmesh@gmail.com.

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