thE hAnDbook of tEchnicAL AnALySiSconvergence as a deviation from the norm. Many markets have a natural inverse
relationship with other markets. In such cases, divergence is actually represented
by the two markets converging on each other, albeit only briefly. In Figure 9.97,
the convergence begins around time line A.
9.6.1.2 examples of inter Contract price Divergence: using ratio spikes
to gauge potential reversals We may also look for divergences between the
prices in back and front months of a futures contract. We simply construct a ratio
or relative strength chart of two contract months and add a fixed percentage en-
velope or volatility band to it. In Figure 9.98, we see reversals in Silver being accu-
rately forecasted, at points 1 to 9, whenever the 20‐day percentage band violated
at the 5 percent breakout level, based on the March and May 2012 contracts.
Breakouts to either side of the band give equally valid signals and provide a fairly
easy and consistent way of gauging potential reversals in Silver. Larger violations
of the threshold are usually preceded by more significant selling climaxes or blow
offs, as evinced by the large price ratio spike at point 7.
In Figure 9.99, reversals in Brent Crude Oil are accurately predicted, at points
1 to 13, every time the thresholds on the fixed percentage envelope are tested or
breached. Threshold A represents a lower percentage threshold while B is set at
a higher percentage. The ratio spikes that test threshold B are usually associated
with larger reversals in Brent Crude Oil. The threshold percentage levels may be
set either via back testing or simply by careful visual inspection. The first sig-
nificant reversal drove oil down to about $107.40. The subsequent pullback was
accurately identified at point 1 where the ratio spike tested the lower percentage
threshold. The pullback was followed by an extended run up in oil prices.
Figure 9.97 Naturally Divergent Markets.
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