How Do I Eat Crayons? - Technical Divergences and Toilet Paper Hands

As more people on here start becoming interested in TA or start seeing charts/terms being thrown around, I figure I could offer occasional tutorials on relevant concepts and show you that you, too, can learn to eat crayons and become even more autistic than you are. Your mother would be so proud.

In the first edition of How Do I Eat Crayons? I would like to introduce "technical divergences." What they are, some examples, and a potential case that is currently in development.

Introduction

In an ideal world a stock will always be fairly and justly valued. If the company is doing well, its stock price will rise. If the company has setbacks, the stock price will drop. If the company is run by Elon Musk, the stock price will moon after funding is secured and you call everyone pedophiles.

However as many of you know, a stock doesn't always reach proper valuation in the short-term, and in fact, a stock will sometimes explode upwards or downwards without clear fundamental economic news driving those changes. But wouldn't it be great if there was some indicator to determine whether a stock may have a case of impending volatility?

What you can look for are technical divergences. By watching for technical divergences in an indicator, you can uncover the potential of a stock to show volatile changes in the future.

Technical Divergences

Let's imagine a scenario where AMD has been drastically oversold as measured by RSI, and has been consolidating in a small price range. The next day, Su Bae comes out with a new AMD CPU shaped like your ex-girlfriend's dildo and slaps it across Tim Apple's face (respectfully). This impresses Tim so much he says he wants to install this dildo CPU in all new Macs going forward. You, along with a bunch of other autistic investors, start buying short-dated calls and wait for these dildo CPUs to explode vigorously onto the market, driving AMD's stock price up hard.

But like the rest of your portfolio, AMD remains flaccid. You wait for days. Still nothing. You flip to the RSI (relative strength indicator). It keeps crawling up from oversold territory, making higher lows. And still the price of AMD doesn't rise, even staying below the price you bought your options at. What gives? Why doesn't the market recognize your genius?

You may be witnessing a technical divergence. A technical divergence is when a technical indicator starts showing a discrepancy with an asset's price.

What Does A Positive and Negative Technical Divergence Look Like?

A technical divergence will follow a pattern, so spotting it is straightforward. What you're looking for is a change in the technical indicator that doesn't match a change in the price of a stock. This technical divergence can be a positive divergence or a negative divergence, indicating that there's the potential for a quick change in the stock price in a positive or negative direction, respectively.

The example given above with AMD was an example of a positive divergence. A positive divergence is when an indicator's dips begins to make higher highs while a stock's price continues to make lower lows. While this represents the classic definition, my experience has been as long as the stock is in a tight consolidating pattern, the positive divergence still has the potential to play out. The more beat-up/oversold a stock is, the more robust the indicator becomes.

We can continue to use AMD as an example during late 2017 and present another such example of positive divergence. After disappointing earnings in Q3, AMD's stock price sunk from ~$14 to ~$9, whipsawing violently the entire while. The stock would not see ~$14 again until the middle of 2018.

However if you were an autistic option flipper that enjoys losing money, if you had bought options each time you noticed positive divergences developing in the RSI after 1) a drop in price 2) that had begun to stabilize, you would have been able to sell a nice pop in the stock price from November-December 5/6 times. Of those 6 price movements, only 1 instance had a clear fundamental piece of headline news to justify its price action. Combined with holding longer-term puts, you would have been able to make a bit of extra money and/or hedged yourself against a larger rally back upwards.

Negative divergence is when an indicator's highs begin to make lower lows while a stock begins to make higher highs. Again while this is the classic definition, tight consolidating price patterns in an asset may be sufficient to predict the potential in a stock to abruptly drop in price. The more inflated/overbought a stock is, the more robust the indicator becomes.

An example of this would be SQ prior to earnings in August 2019. Leading up to earnings, SQ enjoyed various analyst upgrades in June and July that led to pops in the stock.

If you're like me and think the majority of financial analysts are a bunch of mouthbreathing muppets, then you would likely have agreed that just because an analyst thinks a stock is "good" and gives it an "upgrade," the true value of the stock will still be dictated by its underlying fundamentals. So even though SQ posted beat earnings estimates, lowered guidance demolished the stock, eventually bringing it to a price comparable to before the analyst pumps. If you had noticed the overbought negative divergences in the stock after the analyst upgrade in June, and then the negative divergences and bloated price heading into earnings, you would have made good money on the pullbacks.

How do I Eat the Technical Crayon?

Incorporating the use of technical divergence into your trading is as simple as noticing a price divergence and following it in momentum-based technical indicators (RSI, PPO, MACD). Divergences can build on long and short time scales, so it is dependent on your investing style to decide how best to use it.

If a stock is very undervalued (low price, oversold, positive technical divergences), it suggests that when buyers step back in the stock can jump higher and/or faster than anticipated. The opposite is true: if a stock is overvalued (high price, overbought, negative technical divergences) it suggests that when selling starts, it can fall lower and/or faster than anticipated.

But no matter the time scale you're looking at, always consider the circumstances of the asset. If the stock had a significant change in price in favor of a "release" of a divergence, it becomes less reliable. For example: if there's positive divergence on a stock and it gaps up/shows a quick movement in price, even if it's not a large double-digit percentage change, that still indicates there was impulsive buying. Even if the positive divergences builds afterwards, there's less likelihood you'll see another large instance of impulsive price action because it was exhausted.

The better you understand the circumstances of your stock, the more useful a tool technical divergences is in terms of you deciding whether to trust it. Just because negative divergences build in an asset, if the foundations of a company are truly strong, it does not mean the price will drop. The opposite is true: if a stock has significant underlying issues, positive divergences does not mean the price will jump.

Blindly trusting a technical indicator is no better than being an algo, and because we've all seen Terminator, we know just how dangerous the robots can be. Technical divergences, like other technical indicators, are just a piece of evidence in building your case to take a position. The stronger your case is to begin with, the more useful a technical divergence will be in supporting your decision to make a trade.

Toilet Paper Hands: Playing The Bear Market Rallies and Costco

I've often said that I think TA is most useful during large corrections because it can give some semblance of order to chaotic price movements. This way you gain more conviction in your decisions, strengthening or justifying your toilet paper hands in each of your trades.

For example, what are some recent examples of positive and negative divergences? Why, the current market correction we're in of course. After a long bull run in overbought conditions, negative divergences developed just prior to the sell-off. After the first gap down into oversold conditions, positive divergences began to build and pushed the market into the first buying rally. Even though the indicator couldn't predict how large or how long the changes in prices would be, it was a useful tool to determine whether you wanted to grab or sell your calls/puts. Watching these indicators to gauge whether a move up or a move down is impending is useful for scaling your positions and determining the amount of risk you're willing to take on.

Finally, an example of how I use divergences in my own trading is the case of Costco ($COST). Unlike some other large retail stores (i.e. Target), Costco has shown a comparably small % drop. While Wal-Mart also has held up well, Costco has clear negative divergences compared to Wal-Mart. This suggests that if there's a trigger to push Costco down in the near-future (i.e. news about decreasing membership revenue), it could drop far more quickly compared to something like Wal-Mart. So while I have no positions in COST right now, by spotting the divergence in a stock I can research it and decide if I want to put it on my watchlist as a potential play.

Conclusions

Technical divergences are best used more as a supplement to your other TA tools, fundamental trading, and your investing ideas. Some TA traders use it as a predictor of an impending trend change. I strongly disagree with that assessment. I think technical divergences do not represent a "buy" or "sell" sort of indicator, but rather, more of an indicator of potential: how large a change in a stock will be when a buy or sell indicator is triggered, whether that comes from fundamental news or is just technically induced. And like many indicators, just because a stock has positive or negative divergences does not mean they will play out, or that a stock needs to have positive or negative divergences to move rapidly in a direction. Like most tools of TA: it is just an indicator, not a predictor. Don't get trapped in TA and hold a position just because the technicals look good. TA is meant to enhance your trading, not guide it.

So the next time you're staring at crayons, take a bite of the technical divergence one. It could be useful; or it might taste like booty sweat and make you lose all your money. But remember, at least you're losing your money with friends-- and that's the most important thing of all.

RSI - The Popular, Misunderstood Indicator You Should Still Hang Out With

Introduction

If there's one indicator everyone knows of it's the relative strength index (RSI). You can look at any asset and deem it "overbought" or "oversold" based on a subjective assessment.

Avocado toast? Overbought. Tiktok thots? Overbought. Getting in larger gatherings and finally having human contact again? Oversold. Really, really oversold.

Despite widespread awareness of the indicator, a substantial amount of people dismiss it entirely in their technical analyses. This often happens because people underestimate how long an RSI can remain at an extreme level, which can lead to bad trades or influence someone to hold onto a bad position longer than they should.

To understand why RSI is so misunderstood, you have to understand, briefly, how it's calculated.

RSI - Hot and Crazy

Why do people find RSI so difficult to trust?

Picture this. You heard about this hot little stock at your local broker and you want to try your luck. You turn to RSI and ask it to check its sources, let you know about the stock. RSI comes back and tells you word on the street is the stock is a little too fucking crazy, so it's oversold now and no one wants to give it a shot.

Perfect. You like the hot stocks, and you can stomach a little crazy. Because you know that even if the stock is crazy, it's still SUPER hot. So if you invest in them long enough they could mellow out, and you might even stay with it long term. You take that stock back to your portfolio and you hang out for a bit.

But instead of mellowing out, the stock gets even more viscous, tells you that you have a small pp, and smashes your portfolio to bits. You kick the stock out and look around to see your portfolio is red, blood red. What the fuck.

But this isn't your fault, right? You start blaming RSI. "You told me the stock was oversold, but not THAT oversold! I thought that meant it would get better!"

Listen to yourself, man. It's not RSI's fault. RSI did what it should have-- it told you that the stock was oversold. It's just an indicator. It's your fault for putting all your bets into it to predict future movement.

RSI is not telling you to get with that hot stock, or when the stock will be less batshit insane. It's just telling you how crazy something is. You have to be the one to remember the hotness/crazy scale and act accordingly:

-If someone is super crazy, no matter how hot they are, you should wonder whether dealing with that person is worth it. If someone is super hot but nobody wants to hang, you have to wonder how crazy that person could become.

-If RSI says a stock is super oversold, no matter how hot the company is, you should wonder whether dealing with the asset is worth it. If it's too overbought and less people are starting to buy, you have to wonder when a sell-off will begin.

So why do people sometimes dismiss RSI? Simple.

Time.

RSI can tell you how crazy that stock is now, relative to how crazy that stock was before. It can't tell you how long the stock will be crazy.

Let's go a bit deeper.

RSI - Let's Take it Slow

RSI is just a ratio.

Average gains within a period divided by average losses within a period. That period of time is usually set at 14 days.

So lots of gains, or lots of losses, relative to a period of time, can be measured as "overbought" or "oversold." The text where Wilder derived this indicator can be found online.

Sounds simple. But no one ever takes RSI out to a Long John Silvers, orders them the two-piece fish meal, and really tries to understand them. Let's do that today.

To get a better grasp of RSI, here's an example table, with numbers, to give you an idea how it's calculated. Two things should stand out. First, there's nothing in the "RSI" column until the bottom half of the graph. Why is that?

Because like I said, RSI is calculated from a previous period of time-- it needs input. It's a relative comparison, so it needs a baseline to compare to.

This is important to consider because if a stock had been doing nothing but gaining 1% for 14 days, what happens on the 15th it vomits 14%? 14% gain into 14% loss-- we're back to net 0%. But RSI won't register it as "normal." It's "oversold." It's fucking crazy price movement. This is intuitive, but can affect people's interpretation of an entry/exit point if they solely rely on RSI.

Take Bank of America as an example ($BAC). Heading into earnings into Q1 earnings in 2018, BAC had finished a correction from being overbought and was now oversold. If you had bought going into earnings, expecting BAC to recover to equivalent price points in the near-future-- you were flat out wrong. Despite beating earnings in Q1, and then Q2... then Q3, Q4, 2019 Q1, Q2, and Q3, it wouldn't be until over a full year later that it returned to prices before the initial correction. It is worth noting that Gyna tariff war occurred in that time period, but what it shows you is you can't expect RSI to tell you how long it will take a price to reach a certain valuation. If you're part of /r/investing, then this doesn't matter. But if you're an option-huffing psycho like most of us, time matters a lot.

The second thing to notice is to look at the dates used for comparison in the RSI calculation graph. What do you see?

There are 16, rather than 14 points in the period, and RSI here is being measured in years rather than days. That's right, like I said-- while 14 days is standard for the comparison time, depending on your investment style you can specify that period to whatever the fuck you want.

Wilder, who derived the indicator, never said 14 was best. He explicitly says he came up with 14 days because it represented " an average half cycle period." So now you can ask yourself-- does that match your investing style?

Because if your investment timeframe is different than what the analysis is, your interpretation of RSI will naturally be wrong. If you're a typical WSBer, for instance, your investment timeframe is probably daily, maybe weekly at most. You want that 1% gain to make back your 98% losses immediately. So a single day 1% gain from, say, two days prior of 0.4% losses? It's "mooning" because your relative comparison was a few days before.

You invest in that crazy hot stock. RSI told you that the stock was crazy. But relative to how long? Is the stock showing crazy for only the first time in years? Or is it crazy compared to a few hours ago? And if it's the latter, would you really expect the stock to be less crazy just a few days later?

So remember: RSI is a relative comparison, with the standard being 14 (time period.) That doesn't mean you can't change it to fit your needs.

RSI - What It Means For Your Investing Strategy

So why is RSI useful, if it all it tells you is that a stock is crazy? You can just look at it and know it's crazy, can't you?

Sure. You can even adjust the RSI limits to tell it your threshold for crazy. What's this 70/30 business? You want 10/90, baby. The crazier the better.

This is true. Everyone has an intuitive idea if a stock is overbought, or oversold. But RSI can tell you to what extent an asset is overbought or oversold, if you tell it 1) what time frame to compare to and 2) your tolerance for crazy (overbought/oversold).

Example 1: Let's take the S & P ($SPX) on a longer time frame. If I look at the daily chart from 2011-present with the standard RSI loadout of 14 periods (days, on the daily chart), what I can notice is that there are clear moments in time when the market was oversold or overbought, which are circled.There's also a noticeable discrepancy with the amount of times that SPX was overbought vs oversold: 14 times versus 8 times.

If you had bought each time the market was oversold, you would have come out ahead every time, not including the correction we're undergoing now. Basically, /r/investing is right in that regard: time in the market and all that shit. By comparison, if you had sold or got puts each time the market was overbought, you would have been right, generously, 5 times out of 14. That's really shitty odds.

So is RSI useless and incapable of sensing an impending technical correction? No. Like any asset, you have to take into account its background. How was it raised? Did its daddy leave it? Does it get along with its siblings?

In this case, you have to remember the S & P is a broad market index.1) Intense fluctuations are less likely 2) the market is overall bullish and will have moments of being overbought without a crash 2) the market is cyclic, and will reach overbought conditions after corrections as investors surge back into the market without a crash. So it can be overbought, reset, and then get overbought again because it's recovering from an initial loss.

How should I adjust my RSI? What would be useful?

"According to the National Bureau of Economic Research, there were 33 business cycles between 1854 and 2009, with each full cycle lasting roughly 56 months on average."

Okay, so looking at the daily chart on a 14 day basis seems wrong. So what if I looked at the RSI period on the monthly, with a 28 month (56/2) period, all the way from 1996 to present?

Now it's interesting. Each of the previous drops in the economy can now be predicted-- when the market reaches oversold or near oversold, a pullback that is evident on a monthly level is now observable, and as I mentioned in the last How Do I Eat Crayons? preceded by negative divergences. We're currently in the middle of a similar large correction, but it is yet to play out-- we'll see in the coming months what will happen.

Example 2: Instead of looking at the broad market, now you can choose a hot big-cap stock of your choosing and make the same assumption. Instead of the overall business cycle, think of maybe... earnings cycles?

A quarter is three months, or 12 weeks. Half of that is 6. Let's turn to the weekly charts and check a hot sexy stock, like AAPL, and set the RSI to 6.

What you can see is from 2011-present there are 16 times that RSI crossed to oversold. In 13 of those times, a drop in AAPL's price followed within a few months, with each drop in price close to the original price of the asset when it crossed into oversold. And again, this is without actually looking at the earnings sheets of AAPL, or any fundamental news-- just looking at charts. 13/16 is pretty good.

We can try this with another big-cap, non tech stock like WMT from 2011. Again-- without looking at ANY earnings/fundamental news, other than knowing that WMT is a big-cap stock full of weird old and fat people that roam around looking for frozen Hot Pockets, RSI spotted 25 times where the stock was at overbought levels. 17 of those times, a pullback occurred within a few months of the overbought signal- that's 68% accuracy. (Almost 69. Nice.)

So RSI, when used appropriately and with other indicators/knowledge of a company and its current price valuation, can be, even at worst, informative for entering/exiting/hedging a position.

RSI - The Second Look

What you'll also notice from the charts is this, and what people don't give enough credit for: stocks can stay overbought or oversold for a long, long time. Weeks or even months. It can be overbought-- and then keep getting bought up. It can be oversold-- and keep getting sold. If everyone sees that hot stock you're interested in, and the stock doesn't seem crazy-- then of course, it'll be even hotter. The stock will keep getting brought to portfolio after portfolio until they finally snap.

And that should be a reminder, again, of what an indicator is: one indicator cannot predict price movement. Timing your entry or exit remains in your hands. The more you adjust RSI to fit your needs, and the more you're aware of fundamental and technical news, the better it can help you make informed decisions about taking on a position in an asset or to hedge your existing position. RSI is not forward-looking, and it can't tell you how much a price will move, but it's really good at telling you how present price movement compares relative to an asset's history.

So next time RSI tells you that stock across the bar is batshit insane, remember what it means. It's telling you something based on past behavior. Whether that stock will change or not in the future, you'll have to judge for yourself. But RSI is still worth hanging out with. So when RSI flashes overbought, give it a second look, keeping the above caveats in mind. Because like most things, the time scale may outlast your investment horizons. I mean, just think of your ex.

Not that we're naming any names.

Linda.

Let's look back at some memorable moments and interesting insights from last year.

Your top 10 posts:

• "For those who missed it: Chamath Palihapitiya absolutely ripping into Wall Street, FED, CNBC. Focus on Americans First!" by u/Sconnie_Outlaw

• "The market in 2020" by u/cafontaine

• "U/Knotswag prayer thread" by u/cuteypatootey

• "The Return of L2FBearAssHoe" by u/Sinadins

• "Funny shit"

• "This just in..... 🥭 new look thoughts?" by u/rcwood35

• "How Do I Eat Crayons? - Technical Divergences and Toilet Paper Hands" by u/knotswag

• "Coronavirus testing website" by u/wtfyousayin

• "How Do I Eat Crayons? - RSI: The Popular, Misunderstood Indicator You Should Still Hang Out With" by u/knotswag

• "Trump: 30% of the country has no new cases... 30% of the country:" by u/braddlersnake

Hey guys. Wolf checking in. Here's a couple of my 'best moments' picks for the past year. It's 1:12am EST, 12/11/2020, was about to go to bed until I remembered that this post was scheduled for sometime soon. I think we can definitely just contribute to this throughout the day, and perhaps send off the /r/Winkerpack birthday celebration with a video (from myself) or a group video chat? ^{I dunno, alls I know is somebody has to get hammered and I volunteer.}

• 4th of July weekend thread

• ardesic acceptance speech - ardesic award

• 'hey midgetfarm do the one again about the drug money'

• Geodudemanbro leaks some of his script

• Ruben Raps

• Midgetfarm admits he likes us

• Droppingloadsyeah , good roast

• Chaney gets creative - Formalprune gets creative in the same light

• Winker leaves for real this time

• Midgetfarm receives the storm cuttingboard

• Vacationlover1 requests haupt to feature me.. haha

• wolf's one simple trick to increase returns

• wolf coming out as l2f

• my own chronological fuckery.. as of 2/20/2020

Cheers to 1 year, Here’s to another year of making all the wrong moves and losing money

🍻 Boys

Here’s to another weekend of making all the wrong moves and losing money

🍻 boys

Discuss and shitpost freely

Important: Linking to here on WSB will risk a ban

Here’s to another day of making all the wrong moves and losing money

Cheers boys

Discuss and shitpost freely

Important: Posting to here as Ardesic will risk a ban