Do you believe in Divergence?

One of the tools I find to be indispensible on a chart is the MACD. The boring, good old-fashioned MACD with default settings. In addition to its traditional use, the MACD is one of the best tools that can be used to identify divergence patterns with price action.

Divergence is when price makes a new high, but action in MACD is not confirmed - i.e. the MACD makes a lower high than the previous price high.

In the daily chart of SPY, I have highlighted the previous divergences on the chart. New highs in price were not confirmed by new highs in MACD. This can be seen in Divergence 1 and Divergence 4 on the chart. Subsequently, the SPY broke down and we had quite a drop in both instances. On the other hand, when prices made new lows, MACD did not confirm with new lows as can be seen in Divergence 2 and 3. Subsequently, prices went up.

We have what I believe is another such a divergence on the SPY shown by Divergence 5 on the chart. Recent price highs (which happens to be on a strong resistance area by the way), are not being confirmed by a high in MACD. In fact, the MACD is not only declining, but looks ready to cross over below 0.

Now this does not mean that prices will drop for sure, we may just rest here for a while, or make even higher highs. But it does make one be a bit more cautious, even defensive. Raising a bit more cash is not a bad idea, especially with the run we've had in September.

Personally, I always like to have two watchlists to use at any time - a long and a short watchlist. But this week, I will pay extra attention to stocks that are ready to roll over, and I'll be more aggressive with the futures if I see that we are indeed breaking down to lower prices.

Good luck and good trading!