What is divergence?
Divergences that indicate a reverse can be either negative or positive. A negative divergence occurs when an asset’s price is in an uptrend while the indicator moves lower or shows bearish signals. Conversely, positive divergence happens when the price is in a downtrend, but the indicator is moving higher or showing bullish signs. Beginner’s corner:
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Price momentum explained
The length of price swings measures price momentum. Strong momentum is represented by a steep slope and an extended price swing, whereas weak momentum is characterized by a shallow slope and short price swing. Longer upward swings indicate that momentum is rising, while shorter upswings signal weakening momentum and trend strength. Finally, equal-length upswings demonstrate the momentum has remained unchanged. Momentum indicators are typically used to smooth out choppy price action and provide a clearer picture of price swings. Specifically, this allows traders to compare the indicator swings to price swings rather than only having to compare price movements. Divergence can have significant implications for trade management. The amount of divergence is relative, so several patterns can develop in the relationship between the price and an indicator. While divergence does indicate something is changing, it does not always mean the trend will reverse. Instead, it signals the trader should evaluate their strategy options: holding, selling a covered call (selling a call option while also owning the underlying asset), tightening the stop, or selling. Remember, to be consistently profitable is to pick the right strategy for what the price is doing, not what you think the price will do.
Types of momentum indicators
The way to a successful trade lies in the ability to implement the correct strategy for price action. Common types of momentum indicators for measuring price movements include:
Relative strength index (RSI); Stochastic oscillator; Moving average convergence divergence (MACD); Rate of Change (ROC).
Types of divergence
There are two types of divergence, regular and hidden, which can each be either bullish or bearish. While regular divergence can signal potential trend reversals, hidden divergence points to a continuation of the trend (the price continues to move in its current direction). In short, regular divergence exhibits momentum leaving the trend, which could be an early sign of a reversal. Hidden divergence, on the other hand, depicts momentum coming into the current trend, making a continuation more likely.
Regular divergence: Trend reversal signal
Divergence can be either positive or negative. Positive divergence happens when the price of a security makes a new low while the plotted indicator starts to climb. As a result, traders may conclude that the price is losing its downward momentum, and a trend reversal may soon be approaching. On the other hand, a negative divergence is when the price makes a new high, but the indicator makes a lower high, warning of a weakening price trend. The investors can then determine whether to sell the position or set a stop loss in case the price starts to fall. Traders use divergence to assess the underlying momentum in a security’s price and the likelihood of a price reversal. Understanding divergence can lead to lucrative trades since it helps traders identify and respond to changes in price action.
Example of positive divergence
The stock depicted in the chart below is experiencing a prolonged downtrend. Having plotted an RSI indicator on the price chart, we can observe that the RSI is climbing while the price continues to drop. This type of positive divergence can be an early sign that the underlying security price may be reversing. If the security’s price jumps above the downward trendline, this will complete the confirmation, suggesting we take a long position.
Classes of regular divergences
Both bullish and bearish divergences can be classified into three subcategories according to their strength levels:
Class A divergences: The strongest divergences. Class A divergences indicate the best trading opportunities; Class B divergences: Exhibiting less strength than Class A divergences. Class B divergences depict choppy market action and should typically not be followed; Class C divergences: The weakest divergences. Class C divergences also depict choppy market action and should typically not be followed.
Class A bearish divergences occur when prices climb to a new high, but the oscillator can only invoke a lower high than displayed in a previous rally. They usually signal a sharp and powerful reversal toward a downtrend. Conversely, class A bullish divergences happen when prices plummet to a new low as the oscillator reaches a higher bottom than during its previous decline. They are considered reliable signals of an approaching strong rally (short-term sharp upward price move). Class B bearish divergences occur when prices make a double top (a bearish technical reversal pattern that forms after a security reaches a high price two consecutive times with a subtle decline between the two), with the indicator tracing a lower second top. In contrast, class B bullish divergences are demonstrated by prices tracing a double bottom pattern, with the indicator outlining a higher second bottom. Class C bearish divergences occur when prices rise to a new high, but an oscillator stops at the same level it reached during the previous rally. Conversely, class C bullish divergences happen when prices fall to a new low while the oscillator traces a double bottom. Class C divergences are most indicative of market stagnation, i.e., neither bullish nor bearish trends are becoming stronger or weaker.
Hidden divergence: trend continuation signal
Hidden divergence is a continuation indicator, suggesting a possible market entry point in the direction of the trend to profit from its continuation. A hidden bullish divergence happens when the price makes a higher low, but the indicator shows a lower low. It tells us that the oscillator is recharging to go back up again, i.e., an upward trend continues. A hidden bearish divergence happens when the price makes a lower high, but the oscillator is making a higher high. It tells us that the oscillator is creating space to go back down again, i.e., a downward trend continues.
Divergence vs. confirmation
While divergence happens when the price and indicator provide conflicting signals, confirmation occurs when the price and indicator(s) send the same signals. Firstly, as technical indicators are not perfect predictors of future price movements, confirmation is crucial for validating the credibility of trading decisions. Secondly, it is used to establish whether the price movement will continue.
Convergence vs. divergence
Divergence typically means two indicators are moving apart, while convergence shows how they move together. Thus, convergence is the opposite of divergence. It describes the phenomenon of the price of a futures contract moving toward the spot or cash price of the underlying asset over time. In short, convergence is a way to describe the price action of a futures contract. Convergence occurs because the market won’t allow something to trade for two prices simultaneously. If, however, there are significant differences between the price of the futures contract and the underlying security, a risk-free arbitrage opportunity will present itself. Yet, risk-free arbitrage opportunities rarely exist because the futures contract price converges toward the cash price as the delivery date approaches. Ultimately, technical traders pay more attention to divergence than convergence because convergence is assumed to occur in a normal market.
Pros and cons of divergence
Price momentum refers to the direction and speed of price changes. Trading divergence is a valuable strategy for gaining insight into price momentum. Though divergence indicates that something is changing, it does not necessarily mean that a reversal is approaching. Now, let’s look at this method’s main advantages and disadvantages.
Pros
Trading divergence works with various indicators; Divergence can assist in spotting trend reversals; Divergence helps to detect potential entry and exit points; Useful as a stand-alone strategy or in conjunction with other technical tools.
Cons
Can give out false signals, i.e., point to reversals that never happen; Divergence is not present for all price reversals; It cannot be relied on exclusively to predict reversals, as it doesn’t provide timely trade signals; Divergence can last a long time before a price reversal occurs.
In conclusion
To summarize, divergence alerts traders of weakening price trends, helping them assess the likelihood of the price changing direction to find better and more reliable trade entries. As well as reversals, divergences can also indicate the continuation of a trend. However, as is true with all forms of technical analysis, investors should use a combination of indicators and analysis methods to confirm their trading decisions before acting on divergence alone. Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.
Higher high than the previous high; Lower low than the previous low; Double Top; Double Bottom.
Once two highs/lows are established, you connect the tops/bottoms; If you draw a line connecting price highs/lows, you also have to draw a line connecting indicator highs/lows; The indicator highs/lows must also align with the price highs/lows; For divergence to exist, the slope of the line connecting the indicator tops/bottoms differs from the one from the price (one is going up, one down); If you spot divergence, but the price has already reversed and moved in one direction for a while, the divergence should be considered played out; Divergence alerts are more inclined to be accurate in longer time frames; Divergence on shorter time frames will happen more frequently but is less reliable as a signal; Use other indicators to confirm the signal; Remember, momentum strategies are helpful in active trends but not in range conditions where price swings are limited and variable.
