Hidden Divergence - The Silent Thriller
September 24, 2012 at 6:45 PM (QQQ)(DIA)(SPY)(GLD)(FB)
The ability to spot divergence in the Emini Futures gives traders a distinct advantage.
How To Trade Hidden Divergence - The Silent Thriller
Typically when you hear someone speak of divergence in a particular market, they tend to be looking for a reversal or change of trend. In a bullish market they anticipate prices heading lower and in a bearish trend they anticipate prices heading higher.
Ordinary Divergence is easy enough to spot once you train your eyes. In a bull trend price will make a lower low while indicator you are using makes a higher low. In a bear trend, prices will make a higher high while the indicator will make a lower high. That is ordinary divergence and is used as early warning that the momentum in the current direction is waning or has come to an end. Popular examples of the momentum indicators used are the RSI or Relative Strength Index, the Stochastics Oscillator and many others. Of the two mentioned both of these have a range of 0-100. While they are commonly used and readily available in most trading platforms, we have developed several proprietary CFRN Tools we believe do a vastly superior job of identifying divergence more accurately and on a more consistent basis. Make no mistake, understanding ordinary divergence is a tremendous trading technique.
Hidden Divergence is a bit different and in my opinion an even more powerful tool for trading Emini Futures. Unlike ordinary divergence where we are looking for the momentum of a trend to reverse, with hidden divergence we are looking for a signal that the trend will continue. Newton's First Law of Motion tells us that an object in motion tends to remain in motion, and an object at rest tends to remain at rest.
About 1000 AD, Ibn Sina came up with the idea that an object moving in a vacuum would just keep moving forever without slowing down. In the 1700s, Isaac Newton figured out a way to prove this was true using mathematics. If you were out in space and you gave a rock a push, its momentum would keep the rock moving at the same speed in the same direction until it bumped into something. On the other hand, if you put a rock in space and left it there not moving, its inertia would keep it right there, hanging in space, forever (or until something bumped into it or it came under gravitational or magnetic pull).
Unlike Space, on Earth objects slow down due to friction and/or gravity. In the markets, trends slow down in part to the 2nd Law of Thermodynamics one could argue, but for the more readily apparent reason, we will simply narrow our focus to the opposing market forces. Outside the 2nd Law, a unique thing about a momentum move in the markets is that prior to slowing down and ultimately reversing direction, it will quite often increase in velocity towards the end of its move.
The ability to spot and trade hidden divergence is such a powerful tool because it enables you to potentially capture the most forceful part of a trend in a comparitively short period of time. We discussed that with ordinary divergence price will make a lower low in a bull trend but the momentum indicator you are using makes a higher low. With Hidden Divergence the opposite is true. In a bull trend price will make a higher low and the indicator will make a lower low. This is our signal that what we are seeing is simply a pullback in price and not a reversal. In a bear trend, price will make lower high and the indicator makes a higher high. Picture if you can, the train backing into the station so you can still climb aboard.
Trading Hidden Divergence gives us the opportunity to profit by taking advantage of a pullback in an existing trend. Remember, the path of least resistance is when you have the wind (momentum) at your back. The higher probability is that the market will continue doing what it is already doing. (until it doesn't)
Here are examples of Hidden Divergence:
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Many experienced traders contend that of the two types of divergence, the ‘hidden’ variety is a higher probability trading setup. This is based on the very simple fact that hidden divergence as opposed to regular divergence is a trend continuation indicator. Regular divergence is more of a reversal indicator.
S&P 500 Emini Futures
Last night's ESZ2 Tweet produced 2 trades. A 5 point drop and a 3 point drop. Here's the Chart > bit.ly/PhFPah $ES_F #emini
— DeWayne Reeves (@CFRN) September 25, 2012
(ES) S&P 500 Emini Futures
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