Divergence with no effect?

tcpd2004

LGIH has been making higher highs since Aug 19th, but showing lower highs on both the MACD and RSI...classic bearish divergence. But to no effect...until yesterday. It made 4 new highs and 4 lower peaks on MACD & RSI. This leaves me with 2 questions:
1) Is yesterday's 10% drop just long overdue?
2) If so...what took it so long?

I'm new to this, but reading Elder's "Trading for a Living", the Bullish/bearish divergence is supposed to be one of the strongest indicators in technical analysis.

Has anyone else run across a divergence that just wouldn't take hold?

markd

What MACD and RSI are telling you is that the stock is struggling harder to make those new highs. But that doesn't mean the stock is ready to give it up. If you look at April to August, you see a similar pattern for the MACD - each successive high taking longer or adding fewer points than the preceding leg, and yet the stock broke out to new highs.

So I think the lesson is, trend is stronger than divergence. As long as this stock was trading above it's rising intermediate MA (most people use 50), you would have been better off to look for long entries (like bullish divergences, as in July, when MACD made a lower low, but price did not). What MACD and RSI were accurately telling you with the bearish divergences was that there was not a lot more upside in this stock, at least for the time being. But, as I said, that is not the same as saying it's time to short.

Using the Wyckoff approach, the actual clue to lighten up in LGIH, if you were long, was the four tall red volume bars from mid-October to early November. If the trend is truly up, big volume should advance the price. If it doesn't, it means the bulls don't have the means to hold back the selling. Those red bars made the breakout suspect. If you look at the ranging period in July, you'll see the sellers weren't very active, so the breakout turns out to be genuine.

If you are not familiar with Wyckoff's ideas (big money accumulates and distributes a stock by manipulating small money's perception of prices), they might be helpful in understanding the psychology behind the market's twists and turns. There is a Wyckoff blog on the SC site, which is a good supplement to a couple of books - Charting the Stock Market - The Wyckoff Method by Jack Hutson, or Three Skills of Top Trading by Hank Pruden. Or you can go to the original source, Wyckoff himself - google "Wyckoff pdf" and download his course "Method of Tape Reading" from the cdn3.traderslaboratory link. It's all a bit of a slog, but worth it.

A rigorous application of the Wyckoff method requires using point and figure charts, and dispenses with indicators altogether (there was no computer power in those days). But I don't think you need to be that doctrinaire. The point is to understand why prices move as they do. Also, Elders' Force index actually does a pretty good job of tracking accumulation and distribution, especially with longer term parameters like 63 (one quarter) or 251 (one year). Price and Force divergences can be helpful in understanding the longer term potential of a stock.