Divergence reveals when the price of an asset is drifting away from the trajectory suggested by a technical indicator, such as an oscillator, or contrary to other data. It signals that the current price trend might be degrading, potentially forecasting a directional shift.
The Dual Edge of Divergence
Divergence manifests as either positive or negative:
- Positive Divergence: Implies potential upward movement in price. It’s noted when the asset price trends downward while an indicator shows upward momentum or bullish signals.
- Negative Divergence: Suggests possible downward price movement. This happens when the asset price escalates but the indicator points downward or reveals bearish signals.
Key insights to consider:
- Divergence can emerge between an asset’s price and virtually any technical or fundamental indicator. It’s most often leveraged by technical traders observing the contrary movements of technical indicators.
- Positive divergence points to the possibility of a rising price soon, with indicators showing bullish trends as the price continues to decline.
- Negative divergence warns of potential price drops even as an asset’s price peaks, indicated by a decline in supporting technical metrics.
- Divergence should not be the sole determinant in trading decisions. It provides early warnings but not definite trade signals. Divergence might persist over extended periods without immediate price reversals.
- Not all major price reversals showcase divergence. It’s present in some, but not all scenarios.
What Divergence Tells You
In technical analysis, divergence can hint at significant positive or negative price movements:
- Positive Divergence: Occurs when the asset price hits a new low while an indicator, like the Money Flow Index (MFI), begins to rise.
- Negative Divergence: Spotted when the asset price strikes a new high but the indicator shows a lower high.
Traders utilize divergence to gauge underlying momentum and the likelihood of price reversals. For instance, plotting oscillators such as the Relative Strength Index (RSI) on a price chart offers deep insights — if a stock commands new highs but RSI marks lower highs, it signals a potential weakness in the price uptrend. This moment epitomizes negative divergence where traders might exit positions or set stop-loss measures.
Conversely, if a stock prototypes new lows yet RSI trends upwards, it represents positive divergence, hinting that the price downtrend’s strength might be waning, thus foreshadowing an imminent reversal.
Divergence forms the backbone for numerous technical indicators, predominantly oscillators.
Divergence Versus Confirmation
Divergence implies contradictory signals between price and indicator, while confirmation finds confluence between them. Traders seek confirmation signals to secure trade entries and during incumbency to validate ongoing price trends.
Leveraging Other Analysis When Viewing Divergence
Relying solely on divergence can yield mixed results. Divergence isn’t always reliable and doesn’t promise prompt price reversals, making supplementary risk control and additional analysis essential. Divergence can persist without imminent price reactions, so multi-faceted analysis methods are crucial to mitigating unforeseen losses.
Related Terms: Confirmation, Momentum, Oscillators, Risk Control, Price Reversal.
References
- Mark Andrew Lim. “The Handbook of Technical Analysis”, Pages 323-337. John Wiley & Sons, 2015.
- Steve Nison. “Japanese Candlestick Charting Techniques, 2nd Edition”, Pages 225-228. Penguin Publishing Group, 2001.
- Steve Nison. “Japanese Candlestick Charting Techniques, 2nd Edition”, Pages 225-226. Penguin Publishing Group, 2001.
