| When price
and momentum are moving in the same direction, they are said to be "in
gear." There is nothing important to be learned from this state of
affairs except that the trend is healthy. However, when momentum does
not confirm the price, beware that the prevailing trend may be about to
reverse.
In the description of
overbought and oversold conditions in a previous article, we assumed that
the oscillator peaks and troughs at roughly the same time as the price.
This is not often the case, however. An equally likely possibility is
that the momentum indicator will turn ahead of the price.
Think of a pen thrown
into the air. The pen reaches its point of maximum velocity the instant
it leaves the hand. It continues to rise, but at a slower and slower rate
until it is overcome by the force of gravity. Only then does it begin
to fall back toward the ground. The same effect occurs figuratively in
the marketplace, where the price action is the pen, and the momentum indicator
depicts the velocity of its rise.
 Figure
1 looks at momentum in a slightly different way. It shows the price appreciating
in every period, first in increasing amounts, later in smaller increments.
This example shows quite clearly not only how the price continues to rise
but also how the speed or velocity of the advance decelerates before the
final peak. A momentum indicator measures this acceleration and deceleration
factor and presents it in a graphic format.
Figure 2 shows how this works in practice. Point A marks the point of
maximum velocity, but the price continues to rally at a slower and slower
pace until Point C. This conflict between momentum and price is known
as divergence because the oscillator is out of sync with the price. It
is also called negative divergence because rising prices are supported
by weaker and weaker underlying momentum. The deteriorating momentum represents
an early warning sign of some underlying weakness in the price trend.
In one respect, markets are like houses. They take longer to build than
they do to tear down. Markets spend most of their time advancing rather
than declining. This means that the lead characteristics of momentum indicators
are usually more pronounced at market peaks than at troughs. Even so,
divergences also occur at market bottoms, where they are called positive
because momentum hits bottom before price does.
This phenomenon can be likened to a car in neutral gear being pushed
over a hill. As the vehicle progresses down the slope, it gradually picks
up speed, or momentum. Then, as the gradient levels toward the bottom
of the hill, the car slows down. Even though the speed is decreasing,
the car continues to move before it finally slows to a halt. In this example,
the speed of the car should be thought of as market momentum and its position
as the price.
Positive divergences, as shown in Figure 3, tell us that, even though
a price is declining, it is declining at a slower and slower rate. In
this instance, the technical position is said to be improving, or getting
stronger. Indeed, if you think a market is in the process of reaching
its bottom and you do not see a divergence, you may want to reconsider
your analysis, because most market bottoms are preceded by at least one
positive divergence.
It is very important to note that, although they indicate either a deteriorating
or an improving market condition, divergences do not, on their own, signal
that the prevailing trend has reversed. That signal can come only from
some kind of trend-reversal sign generated by the price itself. This cue
could take the form of a price-pattern completion, a moving-average crossover
or some other signal. When this occurs, technicians say that the divergence
has been confirmed by the price.
 Interpreting
negative-momentum divergences can be compared to watching a moving car
that has a mechanical problem. The car has just begun to make a clanking
noise. Nevertheless, the driver is still able to propel the car faster
and faster because the problem is in its early stages. To an observer
from afar who cannot hear the noise, it appears that the car is in great
shape.
Similarly, in the case of a negative-momentum divergence, a market observer
can see that the price is moving higher and higher. To him or her, it
would seem that the trend is perfectly healthy. Indeed, the fact that
prices are advancing gives a misplaced sense of confidence. Yet, if he/she
could see that the underlying momentum is deteriorating, trader would
be far more inclined to sell. By the same token, the driver of the car,
aware from the din under the hood that some serious trouble was developing,
would be inclined to visit the  repair
shop or risk a breakdown. Thus, if we accept the premise that a malfunctioning
car is likely to require more attention the longer an engine problem is
ignored, we should agree that, the greater the number of divergences an
indicator shows, the more serious the consequences of a reversal in trend
when it inevitably takes place.
Another sign of a mature trend occurs when the momentum index moves strongly
in one direction, but the price fails to follow through with any degree
of gusto. This indicates that the price is tired of moving in the direction
of the prevailing trend, for, despite the strong momentum, thrust prices
are unable to respond. This is an unusual but, nevertheless, powerful
phenomenon. Figures 4 and 5 indicate this phenomenon for both market tops
and bottoms, respectively.
*This article is reprinted with permission
and modifications from Technician’s Campus at http://pring.com/.
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