All technical indicators such as Stochastic, MACD, CCI, RSI, Moving Averages are all lagging indicators. They are either derived directly or indirectly from the price or volume of a stock. However, if they formed a divergence with the price, they become leading indicators, allowing you to buy before major trend reversals. Let’s look at the divergence patterns.

Bullish Stochastic Divergence

There are two types of bullish divergence patterns.

Type 1
1. When a stock is in a downtrend, the price is going down and at the same time frame,
2. Stochastic is going up.

Type 2
1. When a stock is in a consolidation area and at the same time frame,
2. Stochastic is going up.

The psychology behind this pattern is simple. The price is dropping, but the trend becomes weaker and weaker with a bullish reversal up ahead. The Type 1 divergence is more bullish than Type 2.

Bearish Stochastic Divergence

There are two types of bearish divergence patterns.

Type 1
1. When a stock is in an uptrend, the price is going up and at the same time frame,
2. Stochastic is going down.

Type 2
1. When a stock is in consolidation area and at the same time frame,
2. Stochastic is going down.

The psychology behind this bearish divergence pattern is the same as the bullish one. The price is going higher, but the trend becomes weaker and weaker with a bearish reversal up ahead. The Type 1 divergence is more bearish than Type 2.

Let’s look at some real examples.

The figure below shows DTV formed a Stochastic divergence on Mar 9 when the stock was still in a downtrend. Soon after the divergence pattern, the trend reversed, and the stock price went from 19 all the way up to 25.5.

The figure below shows two divergence patterns for the same stock. The first one was formed back in mid April as highlighted in blue, and the stock price went from around 9.25 to 15.5. The second one was from last week and that was one of the reasons why I bought this stock. Let’s see how it turns out.

Divergence is a leading technical indicator and is one of the most important indicators in technical analysis. However, one thing to always keep in mind is, no single technical indicator works all the time. When a pattern doesn’t work out, you must sell the stock and look elsewhere. There are thousands of stocks out there, so don’t fall in love with any one stock. You don’t have to be right every time to make money in the stock market. The important thing for you is to make lots of money when you were right and get out of trades with minimum losses as quickly as possible when you were wrong. After all, that’s what technical analysis is all about.

Tags: bearish, bearish divergence, bearish stochastic divergence, bullish, bullish divergence, bullish stochastic divergence, cci, consolidation area, divergence patterns, leading technical indicators, macd, rsi, stochastic, technical indicators

This entry was posted on Sunday, July 12th, 2009 at 1:24 pm and is filed under Technical Analysis. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.