TO CONSIDER

Bear in mind that the significance of the trend being reversed

will depend on the time span of the oscillator. An oscillator

constructed from monthly data will have greater trend reversal

potential than one constructed from daily data. Further,

reverse divergences can be observed in many different types

of momentum indicators with a jagged appearance. Examples

include the relative strength index (RSI), the Chande

momentum oscillator and the demand index. I prefer the rate

of change (ROC).

It’s important to note, however, that reverse divergences

are only valid for raw data because the smoothing process

automatically delays turning points, so the turning point for

the price often occurs after the smoothed momentum has

reversed direction. To get a reverse divergence at a top

requires two peaks for the price and two for the indicator. It

works the same way for bottoms.

IN THE MARKETPLACE

Figure 6 features the British pound with a 39-week ROC. If

you look closely at the end of 1986, you can see the arrow

marking the momentum low is just slightly to the right of the

arrow marking the price low. In 1989, the currency was

forming the second bottom in a double-bottom formation at

a time when the oscillator was touching a multiyear low.