The Divergence Program

Kaufman320-257.divergence

 

 

In this program you can choose:

  • Daily Stocks and ETFs
  • Daily Futures
  • Both Equities and Futures

Each program has multiple portfolios to help fit your investment needs.

DIVERGENCE is a well-known concept that recognizes when two related markets are moving away from each other. We often see this in the major index markets, the S&P and NASDAQ, or in two related stocks such as Dell and Hewlett-Packard.

Our method is called technical divergence, and it occurs when the price moves higher but a momentum indicator moves lower, or when the opposite pattern happens. “Momentum falling” really means that prices are moving higher at a slower rate, a situation that most often predicts change. Chart 1 gives two examples of stochastic divergence (using our own formula), both with prices rising and momentum falling. In both cases this pattern is followed by a drop in prices, then a continuation of the trend. Our Divergence strategy will trade the reaction following the divergence pattern.

Divergence Chart 1

Performance Characteristics

  • This is a short-term strategy, holding a position for an average of 5 to 8 days.
  • It has a low correlation to trend-following because it is taking positions either opposite to the direction of the trend, or at a time when prices are moving sideways.
  • It has a high likelihood of success on individual trades.
  • Profits per trade are smaller than trend-following because trades are held for less time.
  • It works for stocks, ETFs, and futures using the same rules and specifications

Performance of Stocks, ETFs, and futures

We use the information ratio (annualized rate of return divided by annualized standard deviation) to show which markets have the best return for the risk taken. A higher value shows more return for risk. Below zero shows a loss. Chart 2 shows the ratios for the historic simulated performance of 146 stocks dynamically selected based on a combination of high liquidity and above average volatility. The actual number of stocks in the daily signals will vary to include those of particular interest in the current market regardless of capitalization. We will remove stocks, with notification, after a period of low activity or delisting.

Each stock or ETF is traded with an investment of $10,000 and a cost of $8 per transaction. We selected that combination because the Divergence strategy holds trades, on about 4 to 5 days; therefore, per share profits are smaller than long-term programs and commission costs will have a larger impact. You can improve the returns by trading larger positions or by lowering the transaction costs.

Divergence Chart 2

Stock Portfolios

We offer two sample stock portfolios using 10 and 30 stocks. If you need something in between portfolio, for example, a 15-stock portfolio, we suggest you follow the 30-stock portfolio and take the first 15 signals. Because the larger portfolios may not find enough signals all the time, you can pick the first 10 that occur and come very close to the same portfolio returns. The main advantage of a larger number of stocks is the diversification, which results in a smoother performance but generally a lower return. This can be seen in the simulated NAVs in the chart below.

For current performance, please go to the home page and click on "Performance" along the top.

Divergence equities

Chart 3. Performance of two Divergence equity portfolio and the ETF portfolio.

ETFs

We recognize the importance of ETFs and provide Divergence trading signals for the most popular and most liquid. Because many are a composite of stocks, the price patterns tend to be smoother and the trading results somewhat different although equally as reliable as individual stocks. ETFs cover a broad set of markets, from U.S. and global equities to commodities ad bonds. They offer greater diversification than individual stocks, which can move together or reverse together, during times of stress. An ETF can reflect the price of either physical gold or gold shares, with two very difference performance characteristics. Chart 4 shows the information ratio, based on our simulations of 66 ETFs going back 14 years or from inception of trading. Of the 66 ETFs, 83% are profitable.

 

Divergence Chart 4

ETF Portfolios

ETFs include an uneven assortment of stocks, interest rates, and physical markets, making it too difficult to dynamically select items for a portfolio. There tends to be clustering of similar types of ETFs causing concentration and large swings in equity. However, most of these ETFs show good returns over time, and we can pick various portfolios that reflect our interest and weight each ETF equally to maximize diversification.

We’ve picked a single long-only portfolio of 8 sector ETFs as an example. They are EEM (Emerging Market), QQQ (NASDAQ), SPY (S&P), XLF (Financials), XLI (Industrials), XLP (Staples), XLU (Utilities), and XLY (Consumer Discretionary). Daily signals will appear on the Divergence ETFs All Signals report. From January 2003, the NAVs can be seen in Chart 5, at 7.10% annually with a ratio of 0.778, nearly twice that of a passive S&P return. The 8 ETFs had ratios that averaged 0.53, slightly left of the center of the distribution shown in Chart 4. The simulated NAVs for this portfolio are shown on the right in Chart 3. Note that 2007-2008 was a sustained sideways period, but not a significant drawdown.

If you prefer to create your own portfolio, we suggest that you select from 5 to 8 liquid ETFs that represent some diversification, then use the All Signals report to trade. You may track 10 to 20 ETFs but take the first 5 signals that occur, which will result in more positions more of the time.

Futures Markets

Futures are the venue of professional traders because of the high cost and high leverage. They offer access to all aspects of the economy, from interest rates to grain, and include markets throughout the world. Charts 5 shows the simulated results of the Divergence program on 66 of the world’s most liquid futures markets. Results show a high likelihood of success, where net gains are significantly larger than net losses.

Divergence Chart 6

Futures Portfolios

The futures portfolios for the Divergence program use the same method described in the Trend program and can be found in detail in the Articles menu under "Dynamic Futures Portfolios."

Briefly, KaufmanSignals has moved from the traditional concept of fixed allocations, where the emini-S&P gets (for example) 5% and gold gets 3%, to a fully dynamic approach. The fixed allocation method is obligated to take all trades in those markets assigned to the portfolio, whether they are profitable or not. This method worked well during the 30 years that interest rates declined, but has failed during the past 3 to 5 years.

Instead, the new dynamic portfolio ranks the markets by multiple performance criteria, then chooses up to a limited number of markets for each sector. That number is as equal as possible, subject to liquidity and other constraints. All trades are entered with equal risk to maximize diversification, and sectors are volatility adjusted to avoid excess risk. Other risk controls are also used. When there are not enough markets to qualify for a sector, the portfolio will have fewer markets or even none. On average, it will fill 70% of the portfolio. Read more about this in the article.

Sample portfolios are for account sizes of $250,000, $500,000, and $1,000,000. The smaller portfolios trade fewer markets, but all markets are in either the U.S. or Europe, none in Asia. Because of the change to fully electronic markets, we cannot enter on the open in the U.S. and most European markets, which occurs shortly after the close. To make entering orders easier, we post all executions on the close of the day following the trading signals. We suggest that you can improve returns by trading near the time of the old opening, but before the release of U.S. economic reports at 8:30am New York time.

The simulated NAVs from 1992 through January 2016are shown in the chart below. The 10-futures portfolio represents $250K, the 20 is $500K, and the 30 is $1M. Updated performance of these portfolios can be found on the home page of the website under the Performance tab.

Divergence futures

 

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