Indicator Basics: Signals
This is significant as it confirms that price is trending.
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If price fluctuates around a moving average, frequently crossing above and below, this is referred to as whipsawing.
Many indicators tend to imitate the peaks and troughs on the price chart with a series of similar highs and lows. Divergence occurs when the indicator fails to imitate the pattern on the price chart, a sign of trend weakness and likely reversal.
In an up-trend, if price makes a new High (a higher peak than the last) but the indicator fails to do so, that is a bearish divergence.
In a down-trend, if price makes a new Low (a lower trough than the last) but the indicator does not, a bullish divergence occurs.
Unless supported by other indicators, ignore weaker divergences where:
- Price makes an equal High (a double top) and the indicator makes a lower High or price makes an equal Low (a double bottom) and the indicator makes a higher Low; or
- Price reaches a new High and the indicator makes an equal High or price reaches a new Low and the indicator makes an equal low; or
- Peaks or troughs are only marginally different in height (if you need a ruler to distinguish which is higher).
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Failure swings, in overbought or oversold territory, signal that a trend is weakening and likely to reverse. They also add weight to other signals and are identified by either:
- A trough [LL] below the oversold level,
- followed by an intervening peak that does not reach the overbought level,
- then a higher second trough [HL].
- To complete the failure swing the indicator must then rise above the intervening peak.
- A peak [HH] above the overbought level,
- followed by an intervening trough that does not reach the oversold level,
- then a lower second peak [LH].
- To complete the failure swing the indicator must then fall below the intervening trough.
This pattern of highs and lows is identical to a trend reversal on a price chart.
The signal is strongest when the second peak (or trough) is also above the Overbought level (below the Oversold level), though this is not essential for a valid failure swing.
A triple divergence only occurs where a divergence has given an incorrect signal. Instead of reversing direction, price has made a new, higher High (in an up-trend) or lower Low (in a down-trend). If the indicator repeats its signal by making another lower High (in an up-trend) or higher Low (in a down-trend), this is an even stronger signal than the original divergence.
George Lane (Stochastic indicator) identified a weaker form of triple divergence where the third peak is higher than the second.