Education | Technical Indicators | Candlesticks | Chart Patterns
Momentum Divergence
Definition:
Price Headley created Momentum Divergence as a method to compare how strong a stock's price action is compared to the stock's underlying momentum. This indicator takes the Moving Average Convergence Divergence (MACD) indicator with the standard 12,26,9 setting and converts MACD on a scale from 0 to 100, similar the stochastics or RSI oscillators. Headley's preferred settings for the Momentum Divergence lookback period are 15 and 40 bars.
Interpretation:
The traditional way a technical analyst looks for divergences is to draw trendlines from significant low points or significant high points on the price chart, and then comparing the slope of those trendlines to the slope of the corresponding momentum indicator between those same points in time.
In the top panel of the chart below, you'll notice the red MACD line in the case of Microsoft's (MSFT) daily price action. From the first high in MSFT in early May to the new high that occurred in early June, notice how the red MACD line is not making a new high in June but rather making a lower high. This is known as a bearish divergence, as the momentum is not supporting the new high in price. MSFT's stock price makes a new high in early-June near 75 compared to the prior high in early-May near 72.50. Despite this new high, the corresponding momentum as measured by MACD shows a significantly lower high. This results in a downtrending momentum line. As a result, this suggests the stock's breakout is likely to be a fakeout and MSFT is likely to fall. This does occur as the stock breaks back under 72 and heads to the 66 level over just the next week.
Microsoft (MSFT) Daily Chart with Bullish & Bearish MACD Divergences
One of the challenges of the MACD indicator is that it plots MACD levels relative to the stock's price. This means that all things being equal, a higher-priced stock will have a higher MACD reading than a lower-priced stock, even if they have the same pattern. Yet you want to compare apples to apples, and for the exact same pattern, you want the same reading consistently of the strength or weakness inherent in that pattern, across all stocks.
As a result, Price Headley created the Momentum Divergence indicator, which normalizes momentum readings across all stocks between 0 and 100 (with 0 showing the weakest momentum and 100 showing the strongest momentum). The Momentum line is shown in green in the chart of MSFT. The strength of the Price is also plotted in black, also from 0 to 100.
What you can see from this chart is the following:
- Momentum is clearly already strengthening in early-April in MSFT - The green Momentum line turns up off 0 and quickly runs to 100, the strongest possible reading. When price action and momentum both hit 100, this is a very bullish combination as long as both Price and Momentum lines stay above the 90 level. This is the case until early-May, allowing for a 20% profit on the upside in less than 1 month in this example.
- Similarly, momentum is weakening after the first week of May in MSFT - The green Momentum line heads to 0 while the Price line attempts to move higher. When price is over 90 yet Momentum is hitting 0, this is often a short-term bearish situation. I call these bearish set-ups "air pockets." A stock's recent rise is not supported by momentum, and as the stock's Price line drops back under 90 it can quickly experience some turbulence and come down to the 0 line to catch up with the weak momentum. In this case, MSFT flattens out more than declining. But this is still useful information to know that the stock's upside potential is limited versus an increased probability of short-term downside risk or sideways price action. How? An owner of MSFT shares could use this indicator to determine that it is an excellent time to sell Covered Calls. This would allow the MSFT shareholder to collect additional income while the stock was going nowhere until momentum turned back up.
- The intermediate-term filter (using a setting of 40 instead of 15) helps avoid short-term whipsaws from the shorter-term indicator - The short-term momentum line will jump under 90% or above 30% more quickly, while the intermediate-term indicator's turns above 30% or below 90% screen out some of the short-term momentum indicator's false signals. I'm a big fan of using multiple timeframes to help smooth out noise, and like to look at both the 15 and 40 period Momentum Divergences together for confirmation
