Critics have tried to dispel divergence analysis, but these examples show that when executed properly, reliable signals are generated that can help determine market tops and bottoms.
Almost 30 years ago, using a series of networked Apple II computers, I started doing research and began writing about divergence analysis. Over the years, I developed some rather specific guidelines to analyze divergences. In the past few years, there have been a number of articles about divergence analysis that I feel do not allow it to be judged correctly as a technical tool.
In my opinion, these all have one common flaw, as no matter whether they are trying to prove that divergence analysis works or doesn’t work, they only look at the daily data. I have always focused my divergence analysis on the weekly data because I find it to be the most reliable.
Over the years, I have observed consistent weekly patterns in the Relative Strength Index (RSI) that are quite useful in determining both intermediate-term tops and bottoms. Often times, weekly RSI divergences will confirm signals from other technical tools like the on-balance volume (OBV), which gives even greater validation to the analysis.
In these examples, I am using the 14-period RSI with a 21-period weighted moving average (WMA). Typically, at major turning points, you will be able to observe the formation of one or more divergences at overbought or oversold levels that form over a six- to 20-week time period. These divergences then must be confirmed by a move in the RSI below a significant support level or above a key resistance level.
Generally, when daily divergences are formed but no there are no weekly divergences, the daily divergences just signal corrections within the intermediate-term trend. The daily RSI analysis can often be used to identify continuation patterns within the major trend.
Those analysts who are only looking at daily divergences conclude that divergence analysis does not work because they observe a series of daily divergences within an intermediate-term trend. As a result, they are often whipsawed and fail to catch the major trend.
I hope the following examples will encourage readers to do their own analysis, especially on the weekly data, as only then will you have the confidence to act on your divergence analysis.
Let’s look at the weekly chart for Apple Inc. (AAPL), one of the most followed companies of the past decade. This chart covers the period from March 2007 through early-September 2008.
In April 2007, the RSI moved above its 21-period WMA (green line) as AAPL started its rally from the $90 area. Both the price and RSI continued to move higher until July, when the iPhone was released. The stock peaked just below $150, forming a weekly doji with the RSI at 83. During the following three-week correction, AAPL declined 25% from its highs and the RSI dropped back to support in the 55 area.
By the middle of September, the RSI moved back above its weighted moving average and AAPL closed higher for the next eight weeks. By early November, it had reached the $190 level.
The RSI did not make new highs, as it instead formed lower highs, line A, peaking just above 81. After a two-week correction, AAPL again turned higher, and by late December, the stock surpassed the $200 level.
At these new price highs, a second negative divergence was formed in the RSI, line B, as it only reached the 72 level. This suggested that an important top might be forming.
Two weeks after the highs (line 1), the RSI dropped below key support at line C. This confirmed the negative divergences in the RSI, consistent with the completion of an intermediate-term top. Over the next six weeks, AAPL dropped almost 30% before stabilizing in the $115 area.
By the end of March, the RSI had moved back above its weighted moving average. Over the following seven weeks, AAPL rallied slightly above $190. The weekly RSI rallied up to the 65-70 area, but by the latter part of June, it had dropped back below its WMA.
The rebound in the RSI failed at previous support indicted by line C. After a six-week decline, the RSI bounced, but was only able to make it slightly above its WMA. The subsequent violation of the seven-month RSI support, line D, was a strong signal that the downtrend had resumed.
NEXT: Study Important Signals on Daily Chart for Apple