At the
moment, there may be some bullish divergence emerging in the daily chart of the
S&P 500 (SPX) and Russell 2000 (RUT). Divergence between a price and an
oscillator can be a reliable harbinger of future price moves. Since the beginning
of 2016 SPX has been in a strong, sustained downtrend. However, a pivot low was
formed in the middle of January and now it appears as though another price
pivot could be establishing itself in the beginning half of February. Granted,
the price action year to date has formed a series of lower-lows which is often
interpreted as a bearish sign. Yet, when there is bullish divergence in a
price-based indicator it often leads to a swift reversal of prior price action.
For example,
in the chart below it can be seen how the price trend of SPX has diverged from
that of two of its oscillators. That is, the oscillators have formed potential
higher-highs since the beginning of 2016. This could be indicative of impending
bullish price action in the near term.
First, the
Relative Strength Index, RSI, is a momentum oscillator created by J. Welles
Wilder that measures a trading vehicle’s strength by monitoring its changes in
its closing prices. It is considered a leading or coincidental indicator since
it never lags. Since it is an oscillator it is “bounded,” or fixed, between a
value of 0 and 100. Typically, overbought and oversold levels are delineated by
70 and 30, respectively. Moreover, RSI can be used to identify divergence and
confirmation in price action. Divergence can be seen thus far in 2016, while
confirmation was exhibited during the establishment of the August and September
2015 lows (i.e. both SPX and RSI made higher highs).
Additionally,
the Slow Stochastics of SPX indicate bullish divergence may be developing. As
with RSI, Slow Stochastics are forming a series of higher-highs year to date. Slow Stochastics function similarly to RSI
since both are oscillators. That is, these indicators can be useful in
identifying overbought/oversold levels, confirmation or divergence, as well as
price direction. There are two ways to plot stochastics. I prefer to use Slow
Stochastics since it is a smoothed calculation of Fast Stochastics. This
typically leads to less whipsaw and more reliable range identification. Stochastics
are bounded between 0 and 100 but oversold and overbought levels are demarcated
by values of 20 and 80, respectively.
Bullish
divergence shows that bears are losing strength and price internals indicate a
possible reversal. Once a stochastic turns up from its higher low, traders can
go long and place a protective stop below the most recent low in price.
Likewise,
the Russell 2000 displays potential bullish divergence year to date for 2016.
RSI and Slow Stochastics appear to be forming a higher low while price makes a
pattern of lower lows. It should be noted that after the August 2015 sell off,
RUT exhibited a similar price/oscillator pattern where the price ultimately
reversed higher for the next two months.
Traders
could buy SPX or RUT when RSI or Slow Stochastics confirm a reversal higher and
place a stop just below the most recent low around 1845 and 940, respectively. Since
the future is unknown, using sound risk management is paramount in running a
profitable trading system and can be employed on a position level basis with
stop loss levels. Through back-testing and the system design process you as a
trader can determine the ideal amount to risk per trade based on past results,
personal risk tolerance, and the current market environment.
As always,
please feel free to contact me with any comments or questions. Thanks for
reading.
JD
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