Let’s take a moment to look at a fund you may not have been aware of, but that has formed two nice daily divergences which have since resolved that can serve as an educational example.

The fund is DUG, the UltraShort (2 times leverage) Oil and Gas ProShares fund (which moves inverse to Dow Jones Index oil/gas companies), and let’s take a look at its daily chart:

Let’s compare crude oil prices to the DUG (which actually is tied to companies, rather than crude oil prices specifically).  The thinking is that stocks (oil services/providers, etc) can sometimes lead their respective commodity prices.  We’ll also look at crude oil prices shortly.

As Crude Oil prices (chart below) formed a short-term top pattern (complete with negative momentum divergences), DUG also formed a semi-rounded reversal pattern before continuing higher.  What I wanted to point out from an educational standpoint is the lengthy positive momentum divergence that had been building since May, which gave us further clues that downside price action (or upside in Crude Oil prices) was likely about to reverse, and give an opportunity in the opposite direction.

Most of the time, divergences precede short-term trend reversals, and this provides a classic example of the concept.  You could have entered long (DUG) at the break of the 50 day EMA, or when price came back to retrace the support confluence via the crossover of the 20 and 50 day EMA (which was likely the highest probability entry).

Two mini-bull flags formed quickly after this point and almost instantly achieved their target before a lengthy negative momentum divergence began to form in DUG (positive divergence in Crude Oil prices per barrel).  DUG found resistance at the $40.00 per share level, while crude oil itself found support near $110.00 per barrel at the 200 day rising moving average.

Let’s take a look at crude oil’s daily chart:

I had been calling out the positive momentum divergence in previous posts, as well as describing how the 200 day SMA could provide support and a short-term end to the downside swing.  This happened quickly (complete with doji candles), as price began to surge higher, but an interested and unexpected development occurred Friday, which sent crude oil prices down over 5% in a single day (which was ultra-bullish for the broader US Stock Market - not surprisingly).

In fact, Friday’s action just about formed a “Bearish Engulfing” candle pattern, which would have more validity if it occurred at a possible market top, rather than a possible bottom (or support).

Should crude oil violate $110, the ’rounded reversal’ and divergence play would be invalidated, so this will be important to watch.  A break beneath $110 would also reaffirm the strong short-term downtrend (which has already taken prices down 20%) in place.

Always watch what momentum (strength) is doing and monitor trades in real time for signs of continued strength (or weakness) for a better handle on price action as it develops.