Smart Money Back-Test #Divergence #Money

Topic - Smart Money Back-Test

Divergence in an uptrend occurs when price makes a higher high but the indicator does not. In a downtrend, divergence occurs when price makes a lower low, but the indicator does not. When divergence is spotted, there is a higher probability of a price retracement. Figure 5 is an example of divergence and not a reversal, but a change of trend direction to sideways.

Managing Divergence
Divergence is important for trade management. Taking profit or selling a call option were fine strategies in Figure 5. The divergence between the price and the indicator led to a pullback then the trend continued.

It's often referred to as a bear trap, where the false signal draws in shorts and price quickly reverses, if you look at the pivot the price makes below the lower trendline. The signal to enter appeared when the higher low in price agreed with the higher low of the indicator in Figure 6: the small green arrows.

Divergence indicates that something is changing but it doesn't mean that the trend will reverse. It signals that the trader must consider strategy options: holding, selling a covered call, tightening the stop, or taking partial profits. The glamour of wanting to pick the top or bottom is more about ego than profits. Being consistently profitable involves picking the right strategy for what price is doing, not what we think price will do.

What Is the Relative Strength Index?
The relative strength index flags oversold and overbought market conditions. It measures activity on a scale from zero to 100 over 14 days. These conditions often foreshadow short-term changes in trend.

What Is a Stochastic Indicator?
A stochastic indicator is an oscillator that gauges the price of an asset. Like the relative strength index, it throws a spotlight on prices that indicate that an asset is overbought or oversold. It can point to an upcoming reversal.

What Is a Rate of Change Indicator?
Rate of change measures the existing price of a stock versus what its price was on a previous date. The price difference is multiplied by 100. A positive number generally indicates that prices are rising.

The Bottom Line
The most useful way to use a momentum indicator is to know what strategy to use. Price will lead the way but momentum can indicate a time to preserve profits. The skill of a professional trader lies in their ability to implement the correct strategy for price action.