Banks Get Bullish Chart Signal
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While trading with the trend carries a higher probability of success, you can occasionally find great opportunities by taking the contrarian approach to popular belief. When most people share the same bearish sentiment, that is usually when trends change.
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This year, the KBW Banking Index (BKX) trends have been the easiest with which to make money. The BKX has endured a bear market for nearly 11 months. Since establishing its highs in February, the BKX has retraced 27%. Looking at the most recent price action in Figure 1 below, you can see the downtrend has been fairly stable, and from the surface, it appears things will continue lower. In fact, this technical setup had me ready to start shopping for put options. But as I looked closer, I noticed a particularly bullish signal forming within this sector: bullish divergence.
Figure 1 %26#150; Bear Market in the PHLX Bank Index
Divergence occurs when the price of an issue and a technical indicator move in opposite directions. Divergence can be considered bullish or bearish, depending on the direction of its underlying price and which technical indicator is used. A bullish divergence occurs when the stock price continues to make new lows while the technical indicator makes higher lows. Market technicians commonly use this signal to determine when major changes in the direction of price will occur.
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To illustrate a bullish divergence in the banking index, let’s look at one of the most popular technical indicators used, the Relative Strength Index. Figure 2 illustrates the BKX in pursuit of new lows, while the RSI heads upward.
Figure 2 %26#150; A Bullish Divergence Using a 14-period RSI
Examining the group more closely, I noticed similar signals occurring in three of the prominent banks that are used to calculate this index: Citigroup
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To demonstrate this signal on individual issues, I will use JPMorgan Chase
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), the biggest component within the BKX. JPM makes up nearly 10% of the index’s overall weight. The signals are similar across all major banks within the banking sector, so you can apply these concepts to many of this sector’s stocks.Over the past year, JPM has significantly declined and still resides in a downtrend. Figure 3 highlights a similar downward trend in the BKX, which also yields the same bullish divergence.
Figure 3 %26#150; Six-Month Chart of JPM’s Bullish Divergence
The divergence points toward the possibility of potential strengthening occurring in recent price action. However, this alone doesn’t make me want to jump into any bullish trades just yet. As I analyzed long-term charts, I realized that this major correction might be overdone, according to the RSI indicator and major support and resistance levels, which are presented in Figure 4.
Figure 4 %26#150; Five-year Chart of JPM
As you can see in Figure 4, the chart offers an interesting long-term perspective. According to long-term charts, this price action is constructive within the context of the long-term trend. The sell-off generated an oversold signal from the RSI and proposes a long-term bullish divergence.I want to stress that this might not be the best time to jump in and buy banking stocks hand over fist. I’d rather take bearish trades on banks in the short term, or collect profits on existing bearish trades before prices rally. As I mentioned, the realization that this condition exists in these stocks prevented me from buying puts for short-term gains. After all, these companies face many challenges right now.
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When looking for bullish opportunities in these stocks, I suggest waiting for divergence confirmation as a trading signal. Just because the price and indicators are diverging doesn’t mean divergence is a self-fulfilling prophecy, and the issues will automatically rise. After the price confirms this signal’s strength, watch for the stock prices to confirm new short-term highs. Using a recent example of the S%26P 500 Index, Figure 5 displays what a confirmation of a bullish divergence looks like.
Figure 5 %26#150; Three-Month Chart of the S%26P 500 From July to October
Figure 5 showcases a bullish divergence that formed during the market correction back in late July through August 2007. A confirmation of the divergence comes when the index breaks short-term resistance, which is illustrated by the upper-trend line break in mid-September. As a result, prices continued to rise toward relative highs.In closing, divergences are a great way to get the most out of your technical indicator. Aside from generating entry and exit signals, the most productive trading signals that you receive are bullish or bearish divergences. As we have seen in JPMorgan Chase and the overall banking sector, the use of divergences can help determine when a change in trend might be on the horizon.
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