A Divergence To Watch

In Friday's newsletter, I pointed out that the S&P 500 may be setting a short-term cycle low. By the end of the day, the S&P managed to work its way upward, ending with a small gain. It closed above the 50-day moving average (barely, and on below-average volume), but this could be the start of a rebound, similar to the mid-April and mid-June rebounds.

The Stochastic Oscillator is a momentum indicator that is typically used to interpret overbought and oversold levels. It has an active, ‘%K' line, and a smoothed, ‘%D' line. While many analysts suggest it has given a ‘sell' signal when the %K crosses below the %D and below the 80 or 75 level, and similarly, a ‘buy' signal when %K crosses above %D and the 20 or 25 level, its real usefulness is for identifying cycles, likely reversal points, and divergences.

The above S&P 500 chart shows the index rebounding off a recent low, possibly forming a pivot point. We won't know for sure for a few days. But looking at the Stochastics indicator, we see a pattern of lower lows. This is a divergence from the price chart where higher lows occurred.

What does this mean?

The %K of the Stochastics Oscillator essentially takes the trading range of the past ‘X' number of trading days, 20 in the above case, and shows where the stock closed within the range. A high number, near 100, means it closed near the top of the range. A low number near 0 means it closed near the bottom.

A series of lower lows means that each time the stock set a short-term low and rebounded, it didn't rebound as far. There has been less energy in each rebound.

Does this guarantee a larger market reversal or suggest timing for a market downturn? It does neither. But successful trading is a matter if identifying and responding to the probabilities of the situation. We can't look at one indicator, like Stochastics, and determine an exact probability number. But we can ‘make a case', the same way a good prosecutor makes a case for finding the defendant guilty.

Volume patterns can be a good way to add to the picture. The S&P 500 has gone three weeks now without an up-close on above-average volume. That could change on a strong rebound though.

The news potential? That too could be a problem here, with the market increasingly skittish about Fed ‘tapering' and rising interest rates.

This also is not a seasonally strong period for stocks, as a whole. Historical track records do not paint a strong bearish picture, they just suggest a lack of stock accumulation this time of year. That makes a market more susceptible external influences, less likely to brush off negative news.

There isn't enough evidence yet for either the rebound-from-here case or the bear market case. But when divergences start to show up and volume patterns are not confirming the recent market direction, caution is in order.

New speculative bullish positions can be entered. But say, in a bullish market, you typically have five bullish trades and one or two bearish trades. This may be a good time to change the mix. Perhaps only four open positions at a time, one or two bullish, and the rest either bearish or independent (such as straddle trades). Income trades can still be done, but make sure you understand how changes in volatility will affect your positions.

Of course, there's much more you need to know and many more stocks you can capitalize upon each and every day.  To find out more, type in www.markettamer.com/seasonal-forecaster

By Gregg Harris, MarketTamer Chief Technical Strategist

Copyright (C) 2013 Stock & Options Training LLC

Unless indicated otherwise, at the time of this writing, the author has no positions in any of the above-mentioned securities.

Gregg Harris is the Chief Technical Strategist at MarketTamer.com with extensive experience in the financial sector.

Gregg started out as an Engineer and brings a rigorous thinking to his financial research. Gregg's passion for finance resulted in the creation of a real-time quote system and his work has been featured nationally in publications, such as the Investment Guide magazine.

As an avid researcher, Gregg concentrates on leveraging what institutional and big money players are doing to move the market and create seasonal trend patterns. Using custom research tools, Gregg identifies stocks that are optimal for stock and options traders to exploit these trends and find the tailwinds that can propel stocks to levels that are hidden to the average trader.


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