Divergences (of the OBV kind) and how to trade them
Hi all, it’s the Friendly Goomba, back again for a second article in 4 months. Don’t say you’re not spoiled. For those who missed my first epic article, take a gander here:https://medium.com/@RemiG_G/a-brief-review-of-bitcoins-bollinger-band-width-f12bcaddf3bc
Right on the menu today divergences of the OBV (On Balance Volume) kind and how to trade them.
A few weeks ago, I mentioned on Twitter that we seem to see a constant stream of the new tool “du jour”
The one which got my attention was Divergences, I though it’s such an easy thing to spot, it clearly doesn’t require any skills other than being able to tell if 2 trends are going the same way or not.
Kershing, I’m gonna make it big.
Obviously that’s not how it works. How does it work then?
Let’s break things down.
What is a divergence?
Here is what Merriam-webster has to say on the matter
In the simplest of terms, it’s when 2 lines are getting further and further apart. When brought back to trading, the lines we are talking about are the ones form the price and preferred indicators Highs or Lows. I’m sure if you have been on Crypto Twitter for more than a minute, you have see the famous cheat sheet; no, not that wretched Wall Street one, this one:
Applied to the weekly BTC chart, right now we can see a clear HIDDEN BEARISH DIVERGENCE with Higher Highs on OBV and Lower Highs on price.
You’ve found an 11 weeks long divergence, now what? When does the effect kick in, when does the price plunge (if it does at all)? When do you take a position? Any idea?
There’s nothing obvious right now by looking at what I will call a trending divergence.
I’ve spent some time looking at how the candles behave in a divergence and have come up with something which I believe offers a bit more precision. As often in TA, this is an art and not a science.
Before going further, let me tell you about my indicator of choice for divergences.
What is OBV and why choose it?
I’m not going to reinvent the wheel, trying to come up with my own definition, Investopedia has a perfectly good one:
On its own a pretty robust indicator with its own intricacies, and you can see that it was conceived from the beginning to identify divergences.
From my own experience, it also produces more divergence signals than RSI or MACD.
The one thing to have in mind is what happens to the OBV on a candle close, how does it move. This allows you to anticipate the confirmation of a divergence
So, what do we do with it?
OK, now we know a bit more about OBV, let’s get back to that BTC example and see if there is a way to get more a more useful signal.
While we couldn’t clearly see a signal when looking at the trading divergence, we get a 2 if we split the trend and only consider the divergence from one Higher High to another on the indicator side.
In the picture below, if we consider divergence A (Hidden Bearish divergence) running between OBV Highs 1 and 2, we can see that the next candle is a nice big bearish one. Similarly, the divergence B running between 2 and 3results in a bear candle.
The big challenge here is to work out if 2 and 3 are indeed Higher Highs BEFORE the close of the next candle, that’s where the rules used for calculating OBV posted above come into play. These can help you anticipate which way the OBV line is going. Going to lower time frames will help too.
Here is how I have recently tried to use this new found way of reading divergences. In the example below, I have notice that MTL was sitting on good support AND was very clearly showing a bullish divergence, the only question left to answer was:
“Where is the OBV Lower Low coming? This week or the next?”
Because price was at support as I mentioned, I saw little downside here and so gave me confidence that the divergence was going to be confirmed on that candle.
Here is how this is playing out
The bullish divergence got confirmed as the current candle is point to last week being a Lower Low for OBV.
Conclusion
So now you know as much as me when it comes to OBV divergences and how to use them. One thing to be cognisant of is that as OBV relies on volume data and volume is sometimes manipulated by some exchanges, therefore you could get false positive but in my experience, using this point to point approach (rather than looking at trending divergence) mitigates the risk.
This is not a killer indicator/tool but it’s one which I believe should be in anyone’s toolbox and next time Divergence season comes around, you will be equipped to make the most of it.
If you have any questions or comments, reach out, happy to discuss.
Goomba out
