A Technical Signal Giving You Consistent
Profits
The Dynamic Wealth Report
October 14, 2009
by Justin Bennett, Editor
Many of you may have heard this excerpt from “The Road Not Taken”:
“… Two roads diverged in a wood, and I --
I took the one less traveled by, And that has made all the difference.”
It was written by Robert Frost. He was a great poet and playwright from
the early 1900s.
I’m sure Mr. Frost didn’t intend for his epic poem to have anything to
do with trading. However, his poem brings up an interesting trading
concept.
This concept is known as momentum divergence (two signals diverging).
It can guide your trading to new heights…
Divergence works with momentum indicators. Momentum indicators are tools
traders use to measure overbought or oversold levels. One popular
momentum indicator is the RSI. (There are others like MACD and
Stochastics, but we’ll discuss those in a future article.)
RSI is short for Relative Strength Index. It refers to the internal
strength of a stock’s price relative to its historical price performance
measured over a period of time. More simply, it’s measuring how
overbought or oversold a stock is.
Here’s what you really need to know. A reading of 70 and above is
overbought. A measure of 30 or below is considered oversold.
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Some charting programs let you adjust the time setting. A 14-day period
is common for RSI. That’s what we’ll use here.
Now, don’t let the technical mumbo jumbo scare you. RSI is a simple
concept to grasp.
Let me give you a great example…
This is a chart of
Potash (POT). POT is a leading producer of liquid
phosphate fertilizers in North America. Their main customers are
farmers. In 2008, they posted $9.4 billion of revenue.
POT was a darling stock at the start of 2008. Commodities were on a run
and demand for fertilizer was through the roof.
If you had bought the stock at any time in the first quarter of the year,
you’d be seeing some great profits. Of course, you don’t want to risk
giving up all your profits on such a nice trade!
Look at the price chart. The stock ran from a low of $120 and made a
high of $214 in April. It went on to make a higher high of $240 in June. Things are looking strong for POT.
But let’s look a little closer…
Take a look at the RSI indicator at the top of the chart. Notice how the
RSI reading made a high in April right along with the stock.
Now look at the new high in June.
See how the RSI
didn’t make a new high in June while the stock
did (the
blue arrows). This tells us the upside momentum in POT is
weakening. This is called a momentum divergence. It’s when the momentum indicator
(in this case RSI) doesn’t confirm the upward price movement of a stock.
It’s an early warning sign.
If you see this setup in any of your stocks, be ready to sell!
Look what happened. POT plunged like a car driven off a cliff. The stock
eventually hit $60 at the end of November 2008.
.GIF)
By following this simple indicator, you could have saved yourself
thousands of dollars of lost profits.
There are other uses for momentum divergence. Not only will this
technical signal guide you to a good exit point, it’s also very useful
for telling you when
not to buy.
Think back to our POT example. If you saw this upward momentum
divergence, you’d think twice before buying stock at that point. Odds are
a selloff is close at hand.
To be clear, using a momentum divergence signal doesn’t allow you to
pick precise tops and bottoms in the market.
However, it’s a great guide
to prepare you to take action.
Use it as an early warning signal to exit profitable trades. Give it a
quick look before establishing a new position.
By incorporating technical signals like these into your trading, you’ll
have an edge over other less experienced traders.
• Wheat ($5.11 per bushel)
Wheat, as well as corn and soybeans, are starting to show some life. The
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were the culprit. Traders are betting the cold temps will lead to lower
supplies of these commodities than was expected just a few weeks ago.
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