Divergences

Bullish and bearish divergences are where it starts getting interesting. A bullish divergence forms when price moves to new lows, but the Accumulation Distribution Line does not confirm these lows and moves higher. A rising Accumulation Distribution Line shows, well, accumulation. Think of this as basically stealth buying pressure. Based on the theory that volume precedes price, chartists should be on alert for a bullish reversal on the price chart.

The chart above shows Nordstrom (JWN) with the Accumulation Distribution Line. Notice how it is easy to compare price action when the indicator is placed “behind” the price plot. The indicator (pink) and the price trend moved in unison from February to June. Signs of accumulation emerged as the indicator bottomed in early July and started moving higher. JWN moved to a new low in late August. Even though the indicator showed signs of buying pressure, it was important to wait for a bullish catalyst or confirmation on the price chart. This catalyst came as the stock gapped up and surged on big volume.

A bearish divergence forms when price moves to new highs, but the Accumulation Distribution Line does not confirm and moves lower. This shows distribution or underlying selling pressure that can foreshadow a bearish reversal on the price chart.

The chart above shows Southwest Airlines (LUV) with the Accumulation Distribution Line peaking two months ahead of prices. The indicator not only peaked, but it also moved lower in March and April, which reflected some selling pressure. LUV confirmed weakness with a support break on the price chart and RSI moved below 40 shortly afterward. RSI often trades in bull zones (40-80) and bear zones (20-60). RSI held in the bull zone until early May and then moved into a bear zone.

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