Reading though my brokers notes this morning, and came across this, an Interesting look at Divergence and what would have to be an important piece of knowledge to have, whilst trading and avoiding short selling and losing potential profits...Worth a read if you need to freshen up!
Traders often fall into the trap of shorting the market too early for several reasons. One common mistake is overreliance on technical indicators. While indicators like the Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD) can be valuable tools for identifying potential reversals, they can also mislead traders, especially during strong uptrends. Overbought signals may persist for extended periods in a robust uptrend, leading traders to initiate short positions prematurely based on these indicators.
Another contributing factor is the failure to assess the strength of the prevailing trend accurately. Inexperienced traders may misinterpret minor corrections or consolidations within an uptrend as signs of a reversal, leading them to short the market prematurely. Without a solid understanding of trend analysis and the ability to gauge trend strength, traders may enter short positions at inopportune times, missing out on potential profits as the uptrend continues.
Divergences, a popular trading signal used to indicate potential trend reversals, can be invaluable tools for traders looking to avoid premature short positions. Unlike traditional technical indicators, which may give false signals during strong uptrends, divergences offer a unique perspective by highlighting discrepancies between price action and momentum.
Bullish divergences occur when the price of an asset forms lower lows while the corresponding indicator forms higher lows. This suggests that despite the downward price movement, buying pressure is building, potentially signalling an upcoming reversal to the upside. By identifying bullish divergences, traders can avoid shorting the market too early and wait to confirm a trend reversal before entering short positions.
Conversely, bearish divergences occur when the price of an asset forms higher highs while the indicator forms lower highs. This indicates that although the price is rising, the underlying momentum is weakening, potentially foreshadowing a reversal to the downside. By recognising bearish divergences, traders can exercise caution and refrain from shorting the market prematurely, waiting for confirmation of a downtrend before entering short positions.
Let's illustrate this with an example by revisiting the US NDAQ 100 contract. This index has been on the run, and despite the prevailing trend, it has become a magnet for retail traders who want to capitalise on perceived overbought conditions or simply look to be on the “right” side of the trade when sentiment shifts.
The US NDAQ 100 has been in overbought conditions this year and any clean bearish divergences that indicated potential reversals were short-lived, such as the one back in December last year. If we look at the current RSI readings it is indicating a sideways market also known as consolidation with momentum potentially slowing down however there isn’t any confirmed bearish divergences.
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