Divergence

A poorly covered topic in Technical Analysis today is the concept of Divergence and what it actually means. Divergence is associated to leading, or momentum, indicators that have an oscillator as their primary indicator. As we have previously covered, these types of indicators are used in sideways, or ranging periods, and are typically of better used in short-term markets. In saying this, they can be used in longer term markets but are more useful if they are used in conjunction with other indicators.

So what exactly is Divergence? Divergence occurs when price has a different directional reading than that of a momentum oscillator. The strength of these differences indicates the likelihood of a change in market direction and whether a bullish or bearish divergence is occurring.

But, this doesn’t explain what is really is? You are exactly right, because so far we haven’t explained what divergence truly is, but rather how it works, which is what most other websites typically cover without going into the true meaning. Divergence is actually indicating who is driving the market, and who is losing commitment – similar to the length of a price bar and the opening and closing positions depicting who is controlling the market (as outlined in our Basics Tutorial). For example, if a price is forming a new high but the oscillator is not confirming this new high, then a bearish divergence is occurring which usually indicates that the current trend is going to end due to weaker buyer commitment. The reverse is also true.

In order to identify divergence correctly, it is best to classify divergence into differing strengths. The Strongest type of divergence is clearly identifiable and indicates a change in market direction. The following graphic clearly illustrates the strongest type of divergence:

The second strongest divergence is a step down from the strongest divergence and is indicated by price making an equal high or low with the oscillator increasing or decreasing respectively. This also indicates that a trend reversal is imminent but not as conclusive as the strongest type of divergence, and further implies that there is a frailty in either buyer or seller commitment due to momentum increasing or decreasing with respect to price.

The weakest type of divergence is when price has made a lower low or higher high, and the oscillator has made an equal low or high Since the oscillator has not confirmed price by increasing or decreasing in its entirety, this infers that the current momentum has weakened, although not as substantially as other stronger divergence indicators.

Myths of Divergence

It has been suggested by many technical analysts that for divergence to occur in its absolute form, it must fall completely above or below the reference (or centre) line of the oscillating indicator. While many analysts swear by this logic, there is actually no tested evidence to support it. There are many strong divergence signals that occur during transitional swing crosses of the reference line and a lot of these are highly accurate.

In saying this, we are not entirely disregarding this logic altogether but rather suggesting that for more experience technical analysts whom have had experience in clearly identifying mid-swing divergences, there are entry and exit signals available. We would recommend that for less experienced analysts to try and stick to divergences that are clearly identifiable and are well above or below the reference line. As these analysts gain more experience and become increasingly confident with the concept of divergence, then it would be worth trading on divergences during mid-swinging periods of the oscillator reference line.

Multiple Divergences

Typically, divergence is correlated to probability – therefore, the more divergences that are evident in succession of each other, the more likely that a bullish or bearish turning point will occur. Double or Triple divergence are purely single divergences occurring after each other. They can become very complex when different strengths of divergence become apparent, which then led to determining whether or not a turning point is about to occur. An example of both triple divergences is show below:

Remember, like everything in probability, there are no definite answers and only “possibilities”. Although the correlation between multiple divergences and turning points is high, there is no guarantee that every multiple divergence scenario will automatically signal the end of a trend. The more experience that is gained with technical trading, the more a trader will be able to correctly identify true and false divergence indicators.

Trading with Divergences

Divergence trading can get particularly difficult if you are not an experienced trader. This is due to the fact that most divergences occur at turning points and because divergences can have a number of different strengths which can lead to uncertainty about whether or not there is a trading opportunity. While most traders attempt to tackle this problem by using multiple indicators to complement the divergence signal, it does not always prove successful.

The problem is exacerbated further when trading in trends because of a lack of consistency in divergence signals. In these cases, the use of multiple leading indicators is essentially ineffective and lagging indicators will prove much more useful. The author recommends using lagging indicators as trend reversal confirming indicators and divergence as a supporting tool for these indicators. Equally, if a divergence signal occurs before any lagging indicators indicate a plausible trend reversal, then the divergence signal should be used as a warning sign to imply that a trend change is possible and care should be taken if executing trades in the coming period.