Trend Trading for a Living by Thomas K. Carr

Author:Thomas K. Carr
Language: eng
Format: epub
Publisher: McGraw-Hill Education
Published: 2019-12-21T16:00:00+00:00

Figure 10.3 Five-year backtest of pullback setup

CHAPTER 11

THE BULLISH DIVERGENCE SETUP

THE BULLISH DIVERGENCE

Market Type: This setup is best used in:

• Range-bound markets

• Bullish: weakly trending markets

• Bearish: weakly trending markets

Characteristics: This setup is really a workhorse for us. We can use it in all sorts of markets, even bearish ones. The markets spend about 80 percent of their time in range-bound or weakly trending conditions, and this setup works in those conditions very well. Moreover, our bullish watch list will tend to fire off quite a few bullish divergence setups, so you will likely almost always have on one or more of these trades as part of your trend-trading portfolio. The upside to the bullish divergence setup is that it is, along with its bearish counterpart, the one setup we will talk about in this book that has the potential to uncover really large swing moves. Entering a bullish divergence trade may well get you in at the start of a major new cycle move in the stock, especially considering that we are buying only stocks of companies with low price/sales ratios, and that are raising their earnings outlooks. On the downside, holding periods for the bullish divergence setup tend to be longer than for the other setups, so you may need some patience to see those big moves materialize.

As trend traders, we use the bullish divergence setup to pinpoint the bottoms of deep-cut pullbacks (deeper than those of the pullback setup) within long-range uptrends (see following definition). The bullish divergence setup looks for uptrending stocks that are currently in a substantial sell-off and have just put in a series of lower or equally priced lows. This series of pivot lows needs to be at least two lows long so that there is a basis for comparison. After identifying that price pattern (sequence of lower or equally priced lows), the bullish divergence setup then looks at two or more technical indicators. These indicators are used to render the buy signal. A bullish divergence buy signal is registered when the share price prints a lower or equally priced low in a sequence of at least two lows while, at the same time, two or more technical indicators are printing higher lows. This “disagreement” between share price and the indicators is what we call divergence. When price is making a lower or equally priced low, but the technical indicators are making higher lows, that tells us that the relative strength of the downward price movement that is causing these price lows is increasing, not decreasing, at each new low. Or to put it another way, bullish divergence between price and the indicators suggests the downward momentum is decreasing and a reversal to the upside is immanent. This setup provides an opportunity to buy the stock at an unsustainably low price before it rallies back to continue its long-term uptrend.

Key Indicators: This setup relies on both price patterns and a variety of technical indicators. Here are the specifics:

• First, we need to identify the stock as being in a long-range uptrend (see definition).

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