How to Trade Divergence Between Related Index Futures
Analyze Price Action of ES & NQ | October 2nd, 2024
When two related index futures, like the S&P 500 (ES) and Nasdaq (NQ), show divergence—such as ES making a lower low while NQ does not—it signals potential market imbalance or strength in one index compared to the other. Here's how to interpret and trade it:
Implications of Divergence:
1. Relative Strength: In this case, NQ shows relative strength because it fails to make a lower low, while ES does. This suggests that tech stocks (dominated in NQ) might be stronger than the broader market (represented by ES).
2. Potential Reversal: Divergence can be a signal that the weaker index (ES) might reverse soon if the stronger index (NQ) continues to hold firm.
Which Index to Trade:
- Trade the Stronger Index (NQ): Since NQ shows strength by holding above its lows, consider entering a long trade on NQ, expecting it to outperform.
- Fade the Weaker Index (ES): Alternatively, you could short ES, expecting the weakness to persist or catch up to the strength in NQ, but this strategy requires more caution.
How to Trade It:
1. Wait for Confirmation: Look for additional signals (e.g., bullish reversal patterns in NQ or a failed breakdown in ES) to confirm the divergence is actionable.
2. Risk Management: Set stops near recent lows (for NQ longs) or recent highs (for ES shorts) and manage risk carefully, as divergences don’t always result in a reversal.
3. Consider Momentum: If NQ continues to show strength and ES lags, the trade will likely work in your favor. Keep an eye on volume and momentum indicators to validate the strength or weakness.
In general, in divergence scenarios like this, the stronger index (NQ) is often the safer bet for long trades.
In the following chart, ES made a lower low near 9:39 (Oct 2, 2024). A few minutes later, a fractal trough* appeared on NQ (circled area). A good trade would be to buy one tick above the high of bar 3 and set the stop loss either at 1 ATR or the recent low. NQ rallied 250+ points afterward.
*Note: A fractal trough is a series of three consecutive candlesticks (bars) where the middle candlestick has both the lowest high and the lowest low among the three. See glossary here.