Forex Revolution

Forex Revolution



Foreign currency exchange-"Forex"-is today's #1 new investment opportunity. Revolutions in technology, regulation, and globalization have made Forex trading accessible to every active investor. Only one thing has been missing: An objective, clear "user's guide" to Forex trading. Now it's here-and it's in your hands.

Simply and clearly, Forex Revolution reveals everything you need to know to trade Forex hands-on-from fundamental and technical trading strategies to the unyielding discipline that's essential to success.

In this book, Peter Rosenstreich brings together insider techniques from all over the industry: Traders, banks, Forex firms, even the National Futures Association. You'll find expert guidance on everything from handling 24/7 markets to profiting from the emergence of China.

Unlike other books, Forex Revolution doesn't require you to subscribe to costly services or purchase expensive tools. Whether you're an individual investor or a money manager new to Forex, this book gives you all you need: Facts, techniques, resources and-above all-the insider's edge.

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THE SIGNIFICANCE OF PEAKS

The significance of a valid peak/
trough reversal will depend on the
type of trend. The longer the trend,
the greater the significance of the
peak/trough reversal will be. A series
of rallies and reactions that show
up on the hourly charts will be nowhere
near as significant as a reversal in a series of intermediate
peaks and troughs, where the rallies and reactions might
last for several months. If we observe a reversal in a series of
intermediate rallies and reactions, then we would be able to
infer a primary trend, where the expected decline or advance because the low was below the previous low. However, there

was no sign of lower peaks, since the mid-April high was the

high for the move. This is why it does not usually pay to go

with half-signals. It was not until early August that a rally 

peak did not make a new high, and this was confirmed with

a new low, signaling a new bear trend. I cannot say that things

will work out this well every time, because they will not.

However, it is surprising how well this simple tool can help

in improving trading results.

LINES OR CONSOLIDATIONS and WHAT’S A LEGITIMATE PEAK

Sometimes, reactions within a trend develop as a sideways
movement, where the price experiences a trading range.
Figure 4 shows some ranging action following an advance.
(The same could be said in a declining market.) These trading
ranges are also known as lines (as originally referred to in
Dow theory).
Whenever the price experiences a breakout from such a
trading range, it has the same effect as if the range were a rally
or reaction. This means it is possible for a breakout from a
trading range to either act as a peak and trough buy or sell
signal, or a reconfirmation of the prevailing trend. In effect,
when the price breaks out of a line (range), it is violating
Consolidation
takes 1⁄3 – 2⁄3
of the time of
the previous
advance
Consolidation
100% 33 – 66%
Retracement should be
1⁄3 – 2⁄3 of the previous
advance
100%
FIGURE 5: CONSOLIDATION. As a rule, consolidation will take from one-third to two-thirds the time of a
preceding advance or decline. But then —
FIGURE 6: RETRACEMENT. The classic retracement ranges between one-third
and two-thirds of the previous move.
New high!
X
FIGURE 4: HALF-SIGNAL. At X, a lower trough occurs, but subsequently, the high
is taken out and the alert for a downtrend is canceled. Half-signals are not as reliable
as full concordance of peak and trough movement.
several minor turning points that are really
support or resistance areas. Taken together,
they represent the equivalent of more significant
peaks or troughs.
WHAT’S A LEGITIMATE PEAK
AND TROUGH?
Most of the time, the various rallies and
reactions are distinct enough so that it is
relatively easy to identify their turning points
as legitimate peaks and troughs. A reaction
to the prevailing trend should retrace approximately
one-third to two-thirds of the
previous move. Thus, the rally from the
trough low to the subsequent peak in Figure
5 is 100%. The ensuing reaction should then
fall between a one-third to two-thirds correction
or retracement of that move; on
occasion, it can reach to 100%. Technical
analysis is far from precise, but if a corrective
move is less than the minimum one-third, then the peak
or trough in question is suspect.
A line is a fairly controlled period of profit-taking or
digestion of losses, so the depth of the trading range may fall
short of the minimum approximate one-third retracement
requirement (Figure 6). In such instances, the correction
qualifies more on the basis of time than magnitude. It is
important to note that we are dealing with psychology here —
in this case, the bullish psychology associated with the runup
in prices. That sentiment needs to be tempered, either with a
price reaction or with time.
A rule of thumb you might want to use is for the correction to
last between one-third and two-thirds of the time taken to
achieve the previous advance or decline. In Figure 5, the time
length between the low and the high for the move represents
100%. The consolidation prior to the breakout constitutes roughly
two-thirds, or 66% of the time taken to achieve the advance —
ample time to consolidate gains and move on to a new high

HALF-SIGNALS

On occasion, we are left in doubt

whether a trend has reversed. In

Figure 3, we see that at point X

the latest trough breaks below

its predecessor, but not the latest

peak — and only half a signal

has been given. What is now

required is for a fresh rally to

peak below the previous top and

for the price to slip below the

previous low at point Y. This is

a much less timely signal because

the price will have already

fallen from the final high; but by

the same token, the probabilities

of it being a valid reversal

are that much greater. Anyone

not waiting for the signal at Y

would have run the risk of being

left out of a powerful rally such

as the hypothetical one shown

in Figure 4. In that instance,

prices rose and made a new peak,

indicating the trend had never

reversed in the first place. Halfsignals

also appear when a trend

reverses from down to up.

Peak and trough analysis

should be treated as only one

indicator among many in a technical

arsenal. You would not

normally rely solely on a moving

average crossover, oscillator

signal, or trendline violation

to justify entering a trade; similarly,

peak and trough should be

used in conjunction with other

indicators.

The difference with peak and

trough analysis is that indicator

for indicator, it generally offers

a stronger signal than most trendfollowing

techniques. This is

because technical analysis is

very much concerned with the

psychology that underlies price

movements. The fact that a reversal

from a downtrend to an

ANDREW

Peaks And Troughs

The oldest ways of chart analysis had to work in the days

before computers (B.C.). There’s no reason they shouldn’t

work now. Here’s a look at peaks and troughs, a classic form

of chart analysis that worked B.C. and work now.have always thought that, in

general, the simplest techniques

work the best. High up

in this category, and perhaps

the most underrated, is the concept

of peak and trough analysis,

a technique first brought to

our attention as a tenet of Dow

theory. While the theory itself

has lost much of its luster in

recent years, the peak and

trough part of it has not. It is arguably the most important

building block of technical analysis.

When you look at almost any chart, it’s fairly evident that

prices do not go up and down in straight lines, but move in

zigzag patterns instead. During a bull trend, a rally is interrupted

by a correction in which part of the advance is retraced.

This is then followed by another rally, after which a subsequent

correction follows, and so on.

These are the peaks and troughs. As long as a trend

experiences a series of rising peaks and rising troughs, it is

considered to be intact. However, when the series of rising

peaks and troughs is replaced by a series of declining peaks

and troughs, the prevailing trend has reversed.

Figure 1 shows a series of rising peaks and troughs. When

a subsequent rally fails to make a new high for the move (A),

this alerts us the trend may have changed. It is not until the

price slips below the previous bottom (B), however, that the

price action reveals a declining peak and trough. The trend,

according to this technique, is now deemed to be bearish.

In a bear trend, prices continue their downward zigzag

(Figure 2) until the latest trough fails to make a new low for

the move (C). The subsequent rally takes the price above the

previous high (D), and the series of declining peaks and

troughs gives way to a series of rising ones. The actual signal

takes place at E, when it is evident that the price has made a

new high. At that point, we do not know where the next peak

will occur, but we do know it is likely it will be higher than the previous one.As you can see from the price

action at point F, there is nothing

to stop the price from falling

below the trend reversal signal

(E), but pricing will still be consistent

with a rising trend.

CONCLUSION

Finally, another important aspect is the closing tick index reading. I have found that closing tick readings exceeding

+750 are evidence for a potential short-term top. Closing tick readings of +1,000 or more almost always define a

short-term top.

Technically based traders have multiple tools to work with. Some are very complicated while some, such as the tick

index, are simple; some are very well known, while others languish in obscurity. Probably one of the least known is

the tick index - which may be why it works so well.

VARIATIONS

The two reversal patterns discussed do not occur often, so I watch for some variations. First, tops do not necessarily

occur the same day of the extreme high tick reading. If the market is going to make a top, then the day after an

extreme uptick reading is recorded is important. Generally, another high tick reading is recorded following the peak

reading of the previous day. The second day's trading high may exceed the first day's high by more than two and a

half S&P points, and a bearish reversal candlestick pattern (Figure 7) will appear. This condition usually triggers a

short-term sell signal.

In the case of a bottom, after an 800 or higher downtick reading is recorded, the next day the tick reading should

again be at extreme levels. The second day's trading low may exceed the first day's trading low by more than two

and a half points. At that point, watch for a bullish candlestick pattern to appear (Figure 8) for a confirmation of a

buy signal. For bottoms, I noticed that the second downtick reading can be less than or greater than the first bottom

downtick reading. For tops, however, the second top's high uptick reading is less than the first top's.

In runaway markets, the tick index readings will exceed +600 for rallies and -800 for declines for extended periods.

When the difference between the open and closing range for the day exceeds two S&P points, the trend is still intact,

even though tick readings may have reached the upper limits of +600 for tops and -800 for bottoms. This price range

represents the body of a candlestick chart.

No turning point in the market can be anticipated until the difference between the opening and closing price on the

S&P contracts narrows to less than two S&P points, no matter how high the tick readings. In Figure 5, on

November 21, the S&P broke down, ending a consolidation pattern, with a tick reading of -1,070 recorded. No

bottom was anticipated because the body of the candlestick chart for that day was more than two S&P points. The

next day, November 22, a tick reading of -1,340 and the same condition prevailed. On November 23, a -800 tick

reading was recorded and the difference between the opening and closing price was less than two S&P points. This

condition would imply a short-term bottom. You can see on Figure 5 that this is exactly what happened.

Candlesticks For Support And Resistance

Observation is the best friend of the technical analyst. By watching the markets, I noticed something interesting

about candlestick charts, which I use extensively. I realized the real bodies used in candlestick charting can be used

to determine significant support and resistance points, a strategy I had never seen before. Take a look at how it can

be done.

Although they have only recently become popular in the Western Hemisphere, Japanese traders have been using the

candlestick charting technique for hundreds of years. Candlestick charts, much like the bar chart equivalent, utilize

the open, high, low and close activity to plot a period (usually a day). In candlestick charting, unlike bar charting

where the highs and lows tend to be the focus, the opens and closes are the most significant.

A candlestick is composed of two features, as shown in Figure 1. The real body is a rectangle encompassing the area

between the open and close and is what gives candlestick graphs their distinctive appearance. The real bodies are

blacked in if the open is above the close and white if the close is above the open. A session in which the open and

close are the same is commonly referred to as a doji session and is represented by a single horizontal line at that

price.

The shadows of a candle - which give the appearance of being wicks - are drawn in the area above and below the real

body. The upper shadow is the area between the high and the top of the real body, while the lower shadow is the

area between the bottom of the real body and the low. It is possible to have one, two or no shadows. When a

shadow is absent, the result is often referred to as a shaved candle.

Much of candlestick analysis revolves around the search for, and identifying, reversal patterns. Many of the

distinctive terms associated with candlestick charting come into use with reversal patterns. This is where the real

difference between candlestick charting and bar charting comes into play. However, candlestick analysis can offer

more than you think. Most technicians use highs and lows for support and resistance points as part of their basic

charting techniques. But in keeping with the candlestick emphasis on opens and closes, let's change the way we look

at the market. Instead of the usual highs and lows, let's use real-body highs and lows.

The Daily Routine.

Here’s a daily routine that I’ve used in the Strategy:10 system. Some of the most

successful months of my trading career happened when I followed this plan.

Up at 3:00 am EST. Check the charts.

Ask the following questions:

1. Where did the USD close (5pm EST) yesterday against the majors?

2. What effect will today’s economic reports have, if any, on the forex market?

a. FED interest rate movements

b. ECB decisions

c. Unemployment – Weekly Moving Average above or below 400k?

d. Greenspan speaking?

3. Are we at an all time high or low on the EUR or GBP or CHF? Or:

a. Are they way oversold or overbought? Is it better to not trade today?

4. If I make a trade now, what might go wrong? What’s the most I’ll lose? Gain?

Is the market just dead quiet right now? Moving fast?

5. Is the EUR or GBP moving right now? How far are the pairs from support and

resistance?

The 7:10 Principles

1. Buy and sell on breakouts. I teach this in the 1 on 1 training, and I

do it myself.

2. Stop trying to make $8 million on every trade.

3. Set a 10-pip limit only. Exit the trade at 10. Exit the trade at 10.

Stops are set based on market conditions, but are always set.

4. Goal: + 10 pips every day.

5. If I earn more than 10 pips on a trade because the trade moves so

fast in my direction, I can set my stop to protect the 10 and then go

for more. I like to teach traders to just start going for 10. There are

advanced strategies that go for more than 10, but we just start here.

6. There is no ‘makeup’ strategy. If I take a loss, then I’m just trying

to end up with a 10 pip gain for the day. If I can’t get it, then I

don’t try for 20 the next day, or whatever. I can keep trying for the

10 pips gain as long as I haven’t lost more than 5% of my capital.

7. Time: I can trade for 5 hours per day, meaning I can have the

trading platforms open and sit at my computer for a max of 5 hours

per day. If I can’t earn my 10 pips during that time, then I can set

my stops and limits and walk away, but I can’t actively watch the

market any longer.

Stops and Limits

A STOP is placed so that you don't lose too much money. For example, if I

bought EUR/USD at 1.1445, I would start losing money if it started moving down.

So, I might set a STOP at 1.1425 -- meaning, if the currency drops to that level, the

system AUTOMATICALLY exits the trade. I'm out 20 pips, but that's a lot better

than being out 40 pips if it starts tanking really fast (and this happens all the time, as

you have seen).

A LIMIT works the same way, only for gains. If I set my limit to 1.1535 on that

same trade, then later in the day (or the hour), when the currency moves up to 1.1535,

the system AUTOMATICALLY exits the trade, and I make money. This happens

whether I'm still at the computer, or down the street, or dead. THIS IS THE ONLY

WAY TO TRADE IF YOU’RE NOT GOING TO BE PRESENT TO WATCH

THE TRADE.

My system for trading relies heavily on three things:

1. Technical analysis - a ½ hour, 3 hour, daily, weekly, and monthly chart.

2. STOPS and LIMITS.

3. 10-pip goal every day. This requires DISCIPLINE.

If you started with $10,000 on January 1st, and earned 10 pips per day, and only

traded 17 days of the month, then you would end the year 2,000 pips UP, and with

about $130,000. For a spreadsheet that details this system, write me at

rob@robbooker.com.

If you continued the next year with 10-pips per day, the next year you would be

making between $10,000 and $17,000 per month trading (depending on your risk

tolerance). Can you do this? Absolutely. Can you do this today? Maybe, maybe

not. You have to dedicate yourself 100% to learning how to trade intelligently.

A Different Strategy

It’s as simple as this: I don't try to make a ton of money on each trade, and I

never try to get revenge. I’m not a scalper (someone who sits and makes 20-second

trades for a few pips at a time).

Instead, I set up good trades, that have a lot of potential, and then I shoot for 10

pips. Just 10 pips. That’s it. I don’t let myself lose a lot of money. I only try to get

10 pips, and if that’s all I get, then I’m out for the day. It's easy enough to get 10 pips

that once that threshold is met, it's okay to get out. When you know that you can

turn turn $10,000 into $130,000 in one year on 10 pips a day, it's no longer important

to strike back at the market or get greedy on one day of trading.

And you can learn to turn $10,000 into $130,000 in one year on just 10 pips a day.

Why is this innovative, different, or revolutionary? Because you are going to not

only take money from novices with this strategy, you’re going to take money from

other advanced traders. Advanced traders want big money. They didn’t spend years

learning to trade so that they could make $200 a day. They want big, big returns.

They go for 40 pips at a minimum. They are conservative with their trading capital

because the market can take BIG swings against them when they’re waiting for 40

pips. Advanced traders think I’m nuts for getting out of a trade at 10 pips. What if it

goes to 40 pips? Won’t I be upset that I missed out?

Not at all. I’ll show you later how I can still make those 40 pips. But I’m never

displeased with 10. First, though, I’ll explain stops and limits.

Greed and Revenge

Greed

Most traders in the forex market try to make a zillion dollars on every trade.

They're greedy. This leads them to stay in a good trade, hoping to get

more money out of it. This can lead to disaster -- the trade can move against

them and they get creamed. This happens all the time, and it still happens to

me from time to time. It's the single greatest threat in trading. But you can

already understand why that's probably true. But how do you overcome greed

when trading?

Revenge

This is the other big one. A lot of traders get creamed in the market and

then want to strike back. So they double their last order and go for broke.

This is natural, and I still deal with this emotion every day. The problem

is, how does one combat this?

Do not underestimate this emotion. It will drive you to ruin if you let it.

The market is not your friend. The market is so much more powerful than

you are. You cannot get “back at” the market. Trading when angry or

vengeful will be a total disaster. If you get rocked on the market, then back

up, take a deep breath, and talk to a mentor. Re-read the charts. Take a

break. Even if you think you see the best opportunity in the world after you

get blasted – just take a break. There will be trades tomorrow.

A bear chased two hikers. One hiker, while being chased,

One hiker, while being chased,

stopped to put on running shoes.

As he was changing out of his hiking boots, his companion looked at him in

horror and exclaimed, “What in the world are you doing? You’ll never outrun the

bear if you stop now!”

Calmly, the other hiker said, “I don’t have to outrun the bear. I just have to

outrun you.”

The forex market offers more opportunity for fast financial success – and

financial ruin – than almost any other market. The get-rich crowd has always been

attracted to it. This crowd includes speculators, trading novices, retirees, and

professionals looking for a way to get out of debt, increase the excitement in their

lives, or simply get rich really fast.

These are the people who you will be taking money away from. These are the

people who will be eaten by the bear. You don’t have to outrun the bear (the entire

market). In fact, that’s impossible. You can’t beat the entire market. Those of you

who try will learn fast that the market has no mercy, can outrun anyone, and shows

no mercy.

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.

Reverse Divergences And Momentum

An oscillator’s failure to confirm the higher high or the lower

low of the market is a red flag to most technical traders. Is

there a message when the price diverges from the indicator?

This veteran technician thinks there is.

echnical analysts are constantly

comparing prices and indicators

to see whether they are moving in

gear or if there are discrepancies.

It’s when discrepancies appear

that an alert to a probable change

in trend is given. Most traders are

familiar with the concept of momentum

indicators experiencing

positive and negative divergences

by Martin J. Pring

with price. For instance, as you can see in Figure 1, momentum

makes a series of declining peaks as the price works its

way higher. This indicates that the underlying momentum is

gradually dissipating, signaling that a peak in the price may be

at hand. The opposite set of conditions would be true for a

declining trend. The problem with divergences is that you never

know how many to expect prior to the actual trend reversal.

An unusual but normally reliable discrepancy occurs when

price and momentum switch roles (where the price leads the

momentum indicator), the opposite of the normal situation

just described. That’s why I refer to this phenomenon as a

reverse divergence. Figure 2 shows a reverse divergence at a

market peak. See how the price makes its high at point A, then

makes a lower high at point B, but the oscillator makes a

higher high at B. The fact that the oscillator peaks at B as the

price is declining is what makes this a reverse divergence.

Of course, reverse divergences can also fail, so I like to see

some kind of trend reversal in the price as a confirmation. I’ve

used trendlines in these examples, but a reliable moving

average crossover† works just as well. Figure 3 shows a

reverse divergence in action at a market bottom. Note how the

price makes its final low at point A, but the oscillator bottoms

at point B. This phenomenon appears to work so consistently

because prices are determined by many different cyclic

rhythms, and an individual oscillator only reflects a very

small part of that picture. The type of cycle being reflected

will, of course, depend on the time span of the oscillator, so

the longer the time span, the longer the cycle.

When a price peaks or troughs ahead of the ideal cycle

turning point, it indicates underlying strength or weakness,

depending on whether it’s in a downtrend or uptrend. Perhaps

some other cycle not reflected by the specific momentum

indicator being monitored has now become dominant. At any

rate, when the price peaks or bottoms ahead of the oscillator,

there is a strong possibility that a trend reversal will materialize.

EXPERIMENT WITH YOUR FAVORITES

There is nothing magical about the 5-15 price oscillator;

hidden divergences appear on many indicators. Figures 7 and

8 illustrate HDs on the June 1996 bond chart using Williams’

%R† and momentum† indicators, both of which can be found

on most charting software. Different indicators will display

HDs at different places on the price chart, and some indicators

may produce more hidden divergences than others.

The 14-unit Williams’ %R exhibited bullish hidden divergence

at the indicator double bottom at points 1 and 2 as price

made higher lows at each of those points. Other bullish HDs

occurred at points 2 and 3, 3 and 4, 4 and 5 and points 7 and 9.

An indication of a trend reversal appeared at point 10 when %R

made a higher high than it had at either points 6 or 8, but the

price high at point 10 was lower than at points 6 and 8. Price

support at point 9 was broken to the downside following the

bearish HD. The decline continued following another bearish

HD at point 12.

Both bullish and bearish HDs occurred at similar places on

the price chart using a 12-unit momentum indicator on the

same bond chart. (The 12-unit momentum indicator is the

default level on MetaStock software.) Despite bearish classic

divergence at points A, B and C on the momentum indicator as

price moved up above the 120 level during the last four months

of 1995, bullish HDs were evident between points 1 and 2, 2

and 3, 3and 5, and 5 and 7. The first sign of a bearish HD came

in January, when point 6 on the indicator double topped with

point 4 as price made a lower high at point 6. The trend change

was confirmed when price broke support at points 5 and 7. The

second bearish HD occurred at points 8 and 9, which was

followed by a swift five-point decline.

Just as classic divergence does not appear on every price

chart, so it is with hidden divergence. But when HDs do appear,

they are worthy of attention, as they can add to your profit

potential by keeping you on the right side of a trend or by

confirming a trend change. The trick is to train your eye to

recognize a hidden divergence when it presents itself. Now that

you know what to look for, see if you can spot them on the

indicators you like to use.

THE BEARISH HIDDEN DIVERGENCE

In a bearish HD, price makes a

lower high, but the indicator

makes a higher high. This type

of nonconfirmation is mainly

found during corrective rallies

in a downtrend but may

also occur during retests of a

price top. Bearish HDs signal

potential underlying weakness in a security.

An example of bearish hidden divergence appeared on the

June 1995 cattle chart (Figure 4). Following a steady twomonth

decline, price rallied in April to form point 1. After a

brief decline, price rallied again to form point 2, which moved

the indicator to a higher level than it had been at point 1.

However, price made a lower high at its own point 2. The lower

price high, accompanied by a higher indicator high, produced

a bearish hidden divergence, and prices continued their decline.

In May, another price rally ensued, taking both price and

indicator to their respective point 3s. Because the indicator was

higher at point 3 than at point 2 and the price high was lower

at point 3 than at point 2, point 3 would be labeled as another

hidden divergence.

But this proved to be a false hidden divergence, as price rose

above the point 3 high within the next few days. A false hidden

divergence is similar to a false classic divergence in that

momentum has changed but not enough to produce a major

price change. A trendline drawn from the price top of point 2

4 high. The next bearish HD took place at point 6 where the

indicator rose above its point 5 high, but price failed to take out

its point 5 high. Price then continued to decline to the $18 level.

Figure 6 also shows that not all hidden divergences lead to

large price moves. Let me note here, however, that hidden

divergences generally do help to keep a trader on the right side

of the trend.

THE BULLISH

In a bullish HD, the indicator

makes a lower low, but price

makes either a higher low or a

double-bottom low. This type of

nonconfirmation occurs mainly

during corrective declines in an uptrend, but it may also be found on occasion at price retests of

the lows. Bullish HDs indicate underlying strength in the

security and often make good entry or re-entry points.

During its spectacular rise (and before its equally spectacular

decline), Micron Technology [MU] displayed many bullish

hidden divergences (Figure 2) in 1995. At point 2, the indicator

made a lower low than it had at point 1, but price made a higher

CLASSIC DIVERGENCE

Classic divergence is one of the best-known types of

nonconfirmation. A divergence is a separation between price

and indicator that warns of a possible short- to intermediateterm

change of trend. A bullish divergence arises during a

down move when price makes either a lower low or a double

bottom but the indicator makes a higher low or a double

bottom. A bearish divergence occurs during an up move when

price makes either a higher high or a double top and the

indicator makes a lower high or a double top. Classic divergences

can occur at price tops or bottoms and also at price

corrections.

The chart of PepsiCo [PEP] in Figure 1 shows both a bearish

and a bullish divergence. The stock price rose from April to the

end of May 1995. The oscillator made a top in early to mid-May

at point A. However, when price made a top in late May (point

B), the oscillator made a second top at a lower level. This was

a sign that price momentum was decreasing and warned of a

potential change in trend either from up to down or sideways.

The stock made a corrective decline going into July. At the

price low in mid-July (point D), the oscillator made a second

bottom, but at a higher level. This signaled that downside

momentum had decreased and either a potential rally or sideways

move could occur. The bullish divergence was confirmed

as price resumed its up move.