Trading Divergence and Understanding Momentum (2024)

Momentum plays a key role in assessing trend strength because trends are composed of a series of price swings and it's important to know when a trend is slowing down. Less momentum doesn't always lead to a reversal but it does signal that something is changing and the trend may consolidate or reverse.

Price momentum refers to the direction and magnitude of price. Comparing price swings helps traders gain insight into price momentum.

Defining Price Momentum

The magnitude of price momentum is measured by the length of short-term price swings. The beginning and end of each swing are established by structural price pivots that form swing highs and lows. Strong momentum is exhibited by a steep slope and long price swings. Weak momentum is seen with a shallow slope and short price swing.

The length of the upswings in an uptrend can be measured. Longer upswings suggest that the uptrend is showing increased momentum or getting stronger. Shorter upswings signify weakening momentum and trend strength. Equal-length upswings mean the momentum remains the same.

Price swings aren't always easy to evaluate with the naked eye becausethe price can be choppy. Momentum indicators are commonly used to smooth out the price action and give a clearer picture. They allow a trader to compare the indicator swings to price swings rather than having to compare price to price.

Momentum Indicators

Common momentum indicators for measuring price movements include the relative strength index (RSI), stochastics, and rate of change (ROC). Figure 2 is an example of how RSI is used to measure momentum. The default setting for RSI is 14. RSI has fixed boundaries with values ranging from 0 to 100.

There's a similar upswing in RSI for each upswing in price. RSI also swings down when price swings down.

Figure 2: Indicator swings generally follow the direction of price swings (A). Trendlines can be drawn on swing highs (B) and lows (C) to compare the momentum between price and the indicator.

Source: Charles Schwab Strategy Desk

The study of momentum simply checks whether price and the indicator agree or disagree.

Figure 3: Compare price and indicator to make better trading decisions.

Source: Charles Schwab Strategy Desk

Momentum Divergence

Disagreement between the indicator and price is called divergence. It can have significant implications for trade management. The amount of agreement/disagreement is relative so there can be several patterns that develop in the relationship between price and the indicator. Our discussion here is limited to the basic forms of divergence.

There must be price swings of sufficient strength to make momentum analysis valid. Momentum is therefore useful in active trends but it isn't useful in range conditions in which price swings are limited and variable as shown here in Figure 4.

Figure 4: In range conditions, the indicator does not add to what we see from price alone. Variable pivot highs and lows show range.

Source: Charles Schwab Strategy Desk

Divergence in an uptrend occurs when price makes a higher highbut the indicator does not. In a downtrend, divergence occurs when price makes a lower low, but the indicator does not. When divergence is spotted, there is a higher probability of a price retracement. Figure 5 is an example of divergence and not a reversal, but a change of trend direction to sideways.

Figure 5: Momentum divergence and a pullback. Higher pivot highs (small orange arrows) signal price support.

Source: Charles Schwab Strategy Desk

Divergence helps a trader recognize and react appropriately to a change in price action. It tells us that something is changing and the trader must therefore make a decision such as tightening the stop-loss or taking a profit. Seeing divergence increases profitability by alerting a trader to protect profits.

In the stock from Figure 5, Chesapeake Energy (CHK), shares are pulled back to the support. This chart in Figure 6 shows that trends don't reverse quickly or even often. We make the best profits when we understand trend momentum and use it for the right strategy at the right time.

Figure 6: Trend continuation. Agreement between price and the indicator gives an entry (small green arrows).

Source: Charles Schwab Strategy Desk

Managing Divergence

Divergence is important for trade management. Taking profit or selling a call option were fine strategies in Figure 5. The divergence between the price and the indicator led to a pullback then the trend continued.

It's often referred to as a bear trap, where the false signal draws in shorts andprice quickly reverses, if you look at the pivot the price makes below the lower trendline. The signal to enter appeared when the higher low in price agreed with the higher low of the indicator in Figure 6: the small green arrows.

Divergence indicates that something is changing but it doesn't mean that the trend will reverse. It signals that the trader must consider strategy options: holding, selling a covered call, tightening the stop, or taking partial profits. The glamour of wanting to pick the top or bottom is more about ego than profits. Being consistently profitable involves picking the right strategy for what price is doing, not what we think price will do.

Figure 7: Divergence results in range.

Source: Charles Schwab Strategy Desk

Figure 7 shows a divergence that leads to sideways price action. Notice the weakening momentum in moving average convergence divergence (MACD) as price enters a range. This signals that the trader should consider strategy options. We have a disagreement or divergence when price and the indicator are inconsistent relative to each other. We aren't in control of what price will do. We control only our own actions.

Figure 8: Divergence and then reversal of trend.

Source: Charles Schwab Strategy Desk

Sometimes divergence will lead to a trend reversal as shown in Figure 8. The Utilities Select Sector SPDR (XLU) shown in Figure 9 pays a dividend and has options. Understanding trend momentum gives investors a profit edge because there are three ways to profit here: capital gains, dividends, and call premium. This example shows trend continuation after a sideways move, which translates into profit continuation.

Figure 9: Go with the trend when the price and the indicator agree.

Source: Charles Schwab Strategy Desk

The Bottom Line

The most useful way to use a momentum indicator is to know what strategy to use. Price will lead the way but momentum can indicate a time to preserve profits. The skill of a professional trader lies in their ability to implement the correct strategy for price action.