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of the prior rally from May to June. However, the RSI retraced almost the entire prior rally in the RSI. We see this behavior once again at points g and h, where the price that coincides with point h is above the price that coincides with point g, yet the RSI value is lower. When we see this behavior we call it a divergence. A divergence occurs when the momentum oscillator is not reflecting price action. In other words, price will make a higher high, yet the momentum oscillator will not exceed its previous high. This is called a bearish divergence. Inversely, whenever the price makes a new low yet the momentum oscillator fails to exceed its previous low, we are seeing a bullish divergence. In Figure 16-2, we see a bullish divergence, and in Figure 16-6, we see a bearish divergence. |
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The reason it is called either bearish or bullish is because the price will typically sell off after a bearish divergence is formed and rally after a bullish divergence is made. Unfortunately, the majority of traders unconsciously associate a bearish divergence with a bear market and a bullish divergence with a bull market. This association is totally false. An important clue about the market direction is to constantly be looking for a divergence. |
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Now what I am about to say next will cause traders with any rudimentary knowledge of divergences to fry a few brain cells and have smoke come out of their ears! Whenever I see a bearish divergence I immediately start thinking that we are in, or about to enter into, a bull market! Whenever I see a bullish divergence I start thinking that we are in, or about to enter into, a bear market! Yes I know that this flies in the face of what all the textbooks say. |
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The important point is that in the vast majority of cases repeated bearish divergences occur only in an up-trending market, and bullish divergences repeatedly occur in a bearish market. If you find this hard to accept then get a chart of the Japanese yen and start looking at what the RSI did from July 1995 to August 1998. You will be hard-pressed to find a bearish divergence in the daily chart, and there is no bearish divergence in the weekly chart covering a period of 3 years. In Figure 16-5 from the rally commencing in May to October there is no bull divergenceonly bear divergences! Then in late October the RSI did make a bull divergencebut what did the price do? This is the third thing I look at; it is one of my favorite tools. Since the vast majority of traders lose their money, since most traders will sell a bearish divergence, and since most traders are bearish when they are short, I will be waiting to buy! |
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Divergences are associated with any momentum-based indicator. They typically show up at the momentum high or low. When a bull market is overbought, there is a loss of momentum, then a downward correction in price, but not necessarily a trend change. In other words, when a bearish divergence occurs, the market is telling you that it is currently overbought or overextended |
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