Here’s a couple of questions that I received over the weekend regarding when to act on a buy/sell signal and how to recognize divergences on a chart:
Q: I have found your comments and advice to be extremely helpful. While reading your column this weekend, I noticed you talked about 6/10 monthly EMA long term signal for SPX. Do you have to wait till the end of the month for this signal to be valid or can one act on it any time when 6 ema crosses 10 ema, say in the middle of a month. Or does it even matter. I am always confused on this. Thanks for your help.
A: I’ve found that waiting for a print on a close of the period of the chart of whatever signal I am using will greatly reduce the chance of a whipsaw or false signal. On that 6/10 monthly ema, yes, waiting for the 6 ema to close below the 10 ema on the last trading day of the month would be best. The same holds true for breakouts and breakdowns using candlesticks. E.g.- On my weekly charts, I’ll usually wait for a candlestick close on the end of day Friday since intraweek breakdowns are fairly common, only to see prices move back up above the support level by the end of the week. Waiting for prices to print a close above support/resistance on the time frame you are trading even works well with breakouts on intraday charts such as 15 or 60 minute charts (wait for a 15 or 60 minute close above/below the pattern that you are watching). Also keep in that the 6/10 monthly ema pair defines bull & bear markets and those signals typically last over a year once triggered. Therefore, it’s more of a confirmation of the primary trend than a timing signal, more useful for helping to align your trades with the primary trend than a “time to get short” signal as the market will already be well off the highs by the time that it triggers.
Sometimes I will jump the gun and take a breakout before we get a closing print above the pattern. I’ll do that if I have a lot of supporting technical evidence that it will play out and I feel strong about the trade. Right now might be a good time to get an early jump on short trades with most short & intermediate-term signals in the broad market currently bearish. Really it’s just a matter of preference: Aggressive traders might opt to position on any break of support/resistance or on the first crossover of a moving average pair while more conservative or conventional traders, typically those with longer-term time frames, might opt to wait for a solid close below/above the pattern on the time frame that they are trading.
Q: Nice job on the short call. Just curious to whether or not you think a short position should be initiated on FISV. Also, do you use a specific set of rules when drawing Divergence lines? It seems when I’m drawing my own Divergence lines, sometimes I can draw the lines to suite the trade I’m entering(if that makes sense).
A: Absolutely. I’m personally short FISV and plan to highlight it as one of the more promising short trade ideas at this time. FISV just recently broke below the daily uptrend which also defined the weekly ascending channel so it still offers a very nice R/R if shorted around current levels. With that being said, even the most promising trades don’t always play out so always use stops & never get married to any trade.
Regarding divergence, the rules are pretty straight-forward: Using negative divergence, the price of the securities needs to have made a higher high against the indicators or oscillators that you are using (MACD, RSI, CMF, etc..) making a lower low. I will say that although I’ve never read this anywhere, when using the MACD, I consider divergence as only “potential” until we get a bearish cross-over on the MACD while prices made a higher high. In other words, if prices are making a higher high and the MACD has yet to move above its previous reaction high and is still below it, the potential for divergence does exist but it is also possible that the stock keeps moving higher as does the MACD with the MACD eventually moving above the previous reaction high & thereby, negating or eliminating the potential divergence (which tends to happen in strong uptrends). From my experience, if you wait to see the bearish crossover on the MACD (fast line moving below the slow line) at a point that is below the previous reaction high, then the odds of a correction are very high at that point. As far as positive (bullish) divergences, everything that I said above holds true but in reverse (prices making a lower low against the indicators making a higher low).