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Power of Price Divergence

|Includes: TSN, Consumer Staples Select Sector SPDR ETF (XLP)

One of the most profitable ways to trade is by using price divergence. Time and again, if you look retrospective at the top industries the dominated an intermediate up trend, or the weakest industries that dominated an intermediate down trend, they had clear price divergences first. You can profitable trade this one strategy and outperform the markets.

Strength or weakness can be seen in the price action of stocks, industries, or even the markets. A very clear and easy way to use price divergence is to look at a stock or industry and compare its price action to the general market. Let's say that the market has just made a swing low and has starting rallying for a day or two. Let's also say that this is a lower low for the general market. What we would want to do is look for industries and stocks that either: have not retreated and continued to move flat, or have made higher lows in price. These are the strongest areas of the market and will most likely be the first to explode when the market turns around.

Let's look at an example in the market. In the below example, we see that VCI (on the bottom) is making higher lows as the market itself is making lower lows. This type of divergence is incredibly strong showing hidden strength in the stock. An initial buy point after the cup with handle breakout in early January could have been added to as the market rallied off the lows and VCI went on to make new highs (clearing all overhead resistance). Also note the divergence in price related to the moving averages. The S&P 500 sliced through its 50 day quite easily, while VCI held above it in a tight trading range. This showed the support of institutions in this stock, just waiting for the market to turn around. Once the market seems to make a lower low, immediately look through industries and stocks for divergence that will be tradable, and build a watchlist from your findings. This has proven to be one of my most profitable trading methodologies.

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Another sign of strength and divergence is to look for stocks at or near new highs when the market is correcting. This list will surely hold some of the biggest winners during the next leg up in a bull market.

Price divergence works for the short side as well, showing hidden weakness while it is still tradable. When the market has posted higher highs, look for stocks and industries that did not, and add these to a short watchlist for if the market turns. Also look for stocks that are hovering at or near new lows. These will be excellent stocks to short should the market turn.

Another type of price divergence is a difference in corrective or rally percent. This is often used when viewing industry graphs or other indexes where multiple securities are averaged together. It is harder to see strength when a lot of the stocks in a particular group are all together (as when a particular stock is strong and there is no other security to drag on its strength). Below is an example using a top down approach and both types of price divergence. Image

During the market correction in early 2010, the consumer staples sector showed strength, and allowed us to drill down further to find strong stocks in a strong sector for when the market turned up. The bar chart below shows the returns of the SPDR ETF's relative to the S&P 500 for the declining portion of the correction. The large teal bar is consumer staples, and shows the most strength within the basic sectors. In looking at the actual charts of the SPY (When comparing a sector ETF, I like to use the Market ETF for a more accurate comparison) and XLP (consumer staples ETF), we see that the XLP only corrected half (approx 5%) of the SPY or the market. This shows that there was not nearly as much selling and correction taking place in this particular sector. If the market should turn around, a lot of the top performing stocks could be in this sector.

The next drill down is to look at the stocks comprising of this sector, and find stocks that show even better price strength (since the XLP is being dragged by weak stocks, the stocks that are "pulling the average up" should look stronger than the "already strong" sector chart). We are also looking for stocks consistent with other fundamental and qualitative analysis outlined elsewhere in our strategies. Image

The charts to the right start with the SPY or market at the top, the middle is the sector chart (in this case XLP or consumer staples), and Tyson Foods on the bottom (NYSE:TSN). As you can see, consumer staples did not correct nearly as far as the market and even made new highs when the market only retraced half of its correction (blue lines). Now look at Tyson Foods on the bottom. As shown by the blue lines, it actually posted new highs as the market began to correct. It also never retraced during the correction, but held its new highs. It then went on to post higher lows as the market dropped even more. This here would have been a good place to add. Your risk is defined as the last swing low (the first horizontal red line). Tyson then made new highs proving its strength and continued up for a quite a bit.

So as we can see, divergences can show strength and even help give us very low risk entry points. By finding areas where stocks are at or near new highs and the correction was far less than the markets, we can see strength before it rallies hard with the rest of the market. We also see a method of advanced entry in buying as the higher low is made. This can be extremely rewarding and double or triple your reward to risk. However, if the stock then fails to hold its higher low, it should be dumped immediately. Place a protective stop at the first low, and watch the process unfold. A new high long ahead of the market proves and confirms your call and should be left alone until weakness is shown.