What Is Divergence in Technical Analysis?

What Is Divergence?

Within the domain of technical analysis, divergence denotes a scenario in which the price of an asset and a technical indicator, utilized to scrutinize the asset's price movement, such as a momentum oscillator or a moving average convergence divergence (MACD) indicator, manifest contrasting directions.

Divergence is widely regarded as a critical signal for traders and investors, as it may signify a prospective shift in the asset's trend. This implication arises from the suggestion that the momentum propelling the price movement is waning or altering direction, thereby signifying that the prior trend is losing strength and a reversal may be forthcoming.

Types of Divergence

There are two primary types of divergence in technical analysis: bullish and bearish divergence.

Bullish Divergence: This divergence occurs when the price of an asset registers a lower low, while the technical indicator reflects a higher low. This phenomenon indicates that the momentum behind the downtrend is waning, potentially signaling a pending reversal and the initiation of an uptrend. Traders and investors generally interpret bullish divergence as a buy signal.

Bearish Divergence: In contrast, bearish divergence transpires when the price of an asset records a higher high, but the technical indicator exhibits a lower high. This scenario implies that the momentum driving the uptrend is dwindling, possibly suggesting an imminent reversal and the onset of a downtrend. Traders and investors typically consider bearish divergence as a sell signal.

How to Identify Divergence

To identify divergence, the following steps should be taken:

1. Select a technical indicator: Choose a technical indicator for identifying divergence.

2. Observe price and indicator movements: Monitor the price movements of the asset and the movements of the selected technical indicator, focusing on instances where the price and the indicator are moving in opposite directions.

3. Analyze highs and lows: Determine the highs and lows of both the price and the indicator. In bullish divergence, the price forms a lower low while the indicator forms a higher low. Conversely, in bearish divergence, the price establishes a higher high, but the indicator indicates a lower high.

4. Validate the signal: Upon identifying potential divergence, affirm the signal using other technical analysis tools. Seek additional indicators or chart patterns that substantiate the potential reversal signal.

5. Execute trading decisions: Based on the analysis, decide to buy, sell, or hold the asset. It is important to note that while divergence serves as a critical tool in technical analysis, it should not be exclusively relied upon for making trading decisions.

Common Technical Indicators to Identify Divergence

Numerous technical indicators are frequently used by traders to identify market divergence. Some prominent indicators include:

Relative Strength Index (RSI): A momentum indicator that gauges the pace and variations of price movements. It is commonly utilized to pinpoint overbought or oversold conditions and potential trend reversals.

Moving Average Convergence Divergence (MACD): A trend-following momentum indicator that illustrates the correlation between two moving averages of an asset's price. It is widely used to identify trend direction and potential trend reversals.

Stochastic Oscillator: A momentum indicator that measures a security's closing price in relation to its price range over a specific timeframe. It is often employed to discern overbought or oversold conditions and potential trend reversals.

Relative Vigor Index (RVI): A technical indicator that evaluates the strength and direction of a trend. It is commonly employed to identify potential trend reversals and confirm trend direction.

When evaluating indicators for identifying divergence, it is vital to assess their respective strengths and weaknesses, as well as their interplay with one another. Traders should also consider the asset being traded and the timeframe in use, as certain indicators may be more effective for specific assets or timeframes.

Pros and Cons of Divergence in Trading

Similar to any technical analysis tool, divergence exhibits both advantages and disadvantages in trading. Here are some of the pros and cons of employing divergence:

Pros:

Early indication of trend reversal: Divergence offers an early indication of a potential trend reversal, enabling traders to enter or exit positions before the actual shift in direction occurs.

Objective measure of momentum: Divergence provides an impartial measure of momentum, which can serve to confirm or refute existing price trends.

Ease of use: Divergence is easily identifiable through prevalent technical indicators, such as the RSI and MACD, thereby accessible to traders with diversified levels of experience.

Complementarity with other indicators: Divergence can be utilized alongside other technical analysis tools, such as support and resistance levels, to further validate trading signals.

Cons:

Subjectivity: Identifying divergence entails subjective interpretation, potentially leading to differing interpretations of the same data among traders.

False signals: Divergence may produce false signals, especially in volatile markets, prompting traders to prematurely enter or exit positions.

Lagging indicator: Although divergence can signal a forthcoming trend reversal, it is essentially a lagging indicator, meaning it may not precisely predict the timing of the reversal.

Limited applicability: Divergence is most effective in specific market conditions, such as trending markets, and may not be as efficacious in other market conditions, such as sideways markets.

While divergence can serve as a valuable tool in a trader’s arsenal, it should be employed in conjunction with other technical analysis tools, alongside an understanding of its constraints.

Divergence vs. Hidden Divergence

Divergence and hidden divergence represent distinct technical analysis concepts involving the comparison of an asset's price with a technical indicator in order to ascertain potential trend reversals. Despite their apparent similarity, they possess different connotations and implications:

Divergence arises when the price of an asset moves in one direction while a technical indicator moves in the opposite direction. This observation implies a weakening trend and the potential for an imminent reversal.

Conversely, hidden divergence occurs when the price of an asset forms a higher high or lower low, while a technical indicator forms a lower high or higher low. In this context, it indicates the continuity of the trend and the likelihood of the current direction persisting.

While both divergence and hidden divergence serve as valuable indicators of potential trend reversals or continuations, they carry distinct significance for traders. Divergence may prompt consideration of profit-taking or position reversal, whereas hidden divergence may advice maintaining the current position or contemplating further accumulation.

The Bottom Line

In conclusion, divergence is widely embraced by technical traders and can offer an early indication of potential trend reversals. By juxtaposing the price of an asset with a technical indicator measuring momentum or trend strength, traders can discern instances where the price and indicator move in opposing directions, signifying a potential weakening of the trend.

Similar to all technical analysis tools, divergence should be integrated as part of a comprehensive trading strategy, and traders should consistently employ prudent risk management and corroborating indicators to validate trading signals. Through experience and practice, traders can adeptly leverage divergence to identify potential trend reversals and execute informed trading decisions.