Tuesday, February 28, 2006

Analysis: MACD/RSI divergence?

It's 10:30 pm and I am agonizing over SPX. Normally there are greater things in my life than worrying about the next tick, but right here, right now is a point of potentially outsized profits - only if we get the direction right.

So, how does one get it right?

Often, traders use indicators derived from price series, such as MACD and RSI, to estimate future direction. One of the more common and allegedly reliable "setups" implying high odds for the directional outcome are represented by divergences between the oscillators and the actual underlying price series.

Over my years as a stock trader (before options suddenly made a lot more sense) I came to watch these divergences. I saw a lot of them. In fact I saw so many that eventually I saw just as many that "worked" as the ones that didn't.

Today I am seeing both MACD and RSI show such a divergence with respect to SPX and my gut tells me that this just has to work. But, regardless of what it tells me I know one thing: this is a lesson in the making. This is the time to use your brain and do the right thing as a trader, not a compulsive speculator who thinks that MACD, RSI, ROC, or some other squiggly is somehow superior to the very price series they are all derived from. Folks, understand that I don't want to knock these as I know a lot of people swear by them, but if you've seen enough price charts, MACD and friends won't tell you anything radically different from the price itself. In fact, these divergences can be spotted without bringing in MACD or RSI at all!

In case anyone still thinks otherwise, let me state with the utmost degree of conviction that there is no way to tell the future. All one can do is make sensible bets and employ proper asset allocation techniques (or some other form of risk management) to enable yourself to take advantage of this situation. I promise you, noone knows whether this is a top until it becomes (painfully) obvious.

That's why it's a just a carefully measured, calculated bet and that's the only right way to look at it. And so my agony over SPX is over.

Cheers,
/Dmitry

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