What Is Divergence in Technical Analysis and Trading?

The proper knowledge and thorough understanding of different technical indicators are crucial for any trader in making informed investment decisions that align with the trader’s risk appetite and investment goals. One of the concepts that can be highly beneficial for a trader is the divergence in technical analysis.

The concept of divergence in trading germinates from the opposing or diverging direction of the price of the underlying asset in relation to a technical indicator. It means that the price of the underlying security is moving in a direction that is different from the one indicated by a technical indicator.

A divergence is established when, for example, the indicator hints towards an upward movement of the price while the price itself may be going down, or vice versa. By reading this divergence, a trader can preempt a change in the movement of the asset’s price and accordingly make an investment decision.

The divergence can either be upwards or positive, also referred to as bullish divergence, or it can be downwards or negative, also referred to as bearish divergence. In both cases, the divergence reveals the possibility of a change in the momentum of the asset’s price. While divergence is not a definite signal, it can, however, be read as a leading signal. Also, it is not necessary that every momentum change is preceded by a divergence, nor, all divergences culminate in a change in the momentum of the underlying asset’s price.

Types of Divergence in Technical Analysis

There are two types of divergences in technical analysis.

• Positive Divergence: Also referred to as a bullish divergence, it is a situation where the price index reaches a lower peak, but a technical indicator would show otherwise and hint towards a higher peak. The positive divergence means that the asset may go for a bullish trend and its price may rise. The traders and investors typically read positive divergence as a buy signal.

• Negative Divergence: Also referred to as a bearish divergence, it is a situation where the price index reaches a higher peak while a technical indicator falls to a lower peak, or remains stagnant. These differing pathways suggest that the upward trend of the asset may weaken and the price of the asset may fall. The traders and investors usually read this divergence as a sell signal.

Steps to Identify Divergence in Trading

1. First, you will have to choose a technical indicator to identify divergence.
2. Once you have selected a technical indicator, you will have to monitor the asset’s price movement and compare its directions.
3. If the comparison of the asset’s price movement and technical indicator shows they are heading in different directions, then you may have found the divergence.
4. Once you have found the divergence, you will have to confirm it by corroborating it with more indicators and chart patterns from other technical analysis tools.
5. If the divergence signal is confirmed, you are good to go ahead with making an informed investment decision that aligns with your financial goals and risk appetite.

Technical Indicators Used to Identify Divergence in Trading

There are several technical indicators that are used by traders and investors in identifying divergence in trading. Here are some of the technical indicators used for this purpose.

Relative Strength Index (RSI)

This oscillator indicator is usually used to identify oversold or undersold assets. It measures the speed and change of the underlying asset’s price movement. The RSI is used to find a divergence when the indicator’s highs or lows differ from the highs or lows of the asset’s price.

Relative Vigor Index (RVI) 

This momentum indicator compares the asset’s closing price to its trading range and gives insight into the strength of the trend. It is particularly used in trending market conditions. A divergence can be identified when the trend established by the RVI differs from the asset’s price movement.

Moving Average Convergence Divergence (MACD)

It is a trend-based indicator which is used to identify trend direction, duration, strength and reversals. The MACD tracks the relationship between two moving averages and is calculated by subtracting the 26-day period of the exponential moving average from the 12-day period of the exponential moving average. A divergence is detected when the price reaches a higher high or lower low, but the MACD forms the opposite.

Stochastic Oscillator

It is used to identify overbought and oversold stocks. This indicator compares the asset’s closing price to its price range over a period of time. A divergence is identified when the price of the asset differs from this indicator’s peaks or troughs.

Advantages and Disadvantages of Divergence in Trading

Like with other technical analyses used in trading, there are pros and cons associated with divergence in trading. Here is all you need to know about its strengths and shortcomings.

Advantages of Divergence 

1. It provides an early indicator of potential changes in the price momentum.
2. It is an objective indicator that can be used to confirm or refute price trends.
3. It can be easily identified, which makes it handy for traders and investors of varying experiences.

Disadvantages of Divergence 

1. It can trigger false signals when market conditions are volatile.
2. While divergence signals a change in price momentum, it does not identify the exact timing of the reversal.
3. It is not suitable for certain market conditions, like when the market is going sideways.

Mistakes to Avoid

A trader should always be careful and take due measures when using divergence. A mistake that must be avoided is to use divergence in isolation. It should never be done. Rather, a trader should always use other corroborative indicators to confirm the signal received from divergence. Also, verifying the trading volume is one of the ways to confirm the divergence. A low volume would mean a weak signal, while a high volume would suggest strong divergence.

Conclusion

Trading and investing in stocks is a lot more than putting your money into assets. An efficient trader knows that reading and understanding indicators is crucial in making informed investment decisions. While divergence is an effective way to preempt the price movement of an asset, you must stay careful and never rely solely on it. You must always use corroborative indicators to confirm the divergence signal.

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