Candlesticks with Technical Analysis: Divergence

 

 

 

Candlesticks by themselves are a powerful tool for analyzing the supply/demand dynamics. The well studied and time tested candlestick signals give a high probability reading as to who is in control of the stock/market, the bulls or the bears. However, use of technical analysis in combination with candlestick charts greatly enhances the probabilities of being on the right side of the market. One of the technical analysis tools is Divergence.

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Using Stochastics as our primary oscillator, Divergence can be two types.

1. The stock makes a new high, but the stochastics do not and

2. The stock makes a new low but the stochastics do not.

The first case signals an impending reversal to the downside and the second case indicates a high probability of the stock turning back up. However, when you combine this knowledge with analyzing the candle formations, you not only get the confidence to enter a long or short position, but also know the precise entry point.

The chart below shows CHENNPETRO showing a bearish divergence. Notice that while the stock made a higher high, the stochastics actually trended down. This was an alert to the candlestick trader that things are not what they seem. A Hanging Man formation confirmed that the bears have started taking control. Short positions entered after confirmation of the candlestick signal lead to good profits on the down side.

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