What Is Technical Divergence?
In technical analysis, most indicators can give three different types of trading signals: crossing over a major signal line, crossing over a centerline and indicator divergence. Divergence occurs when an indicator and the price of an asset are heading in opposite directions. Of these three signals, divergenceis definitely the most complicated for the rookie trader, so let's take some time to walk through what technical divergence is and how to use it.
Key Takeaways
- Divergence occurs when an indicator and the price of an asset are heading in opposite directions.
- Negative divergence happens when the price of a security is in an uptrend and a major indicator heads downward.
- Conversely, positive divergence occurs when the price is in a downtrend but an indicator starts to rise.
- Divergence is usually a reliable sign that the price of an asset may be reversing.
- Indicator divergence can occur over extended periods of time, so tools such as trendlines and support and resistance levels should also be used to help confirm reversals.
Understanding Technical Divergence
Negative divergence happens when the price of a security is in an uptrend and a major indicator—such as the moving average convergence divergence (MACD), price rate of change (ROC), or relative strength index (RSI)—heads downward.
Conversely, positive divergence occurs when the price is in a downtrend but an indicator starts to rise. These are usually reliable signs that the price of an asset may be reversing.
When using divergence to help make trading decisions, be aware that indicator divergence can occur over extended periods of time, so tools such as trendlines and support and resistance levels should also be used to help confirm the reversal.
Understanding divergence, however, can lead to the most profitable trades, because it helps the trader recognize and respond to changes in price action. It signals that something is changing and the trader should consider his options, whether that is to sell a covered call or to tighten a stop. The problem comes when the ego gets in the way of making a profitable trade—you must take the correct action based on what the price divergence is actually doing, not what you think it may do in the future.
Divergences tend to be either bullish or bearish and are classified by strength. A Class A divergence is stronger than a Class B and a Class C divergence is the weakest of them all. Experienced traders tend to ignore Class B and Class C divergences as simply indicators of a choppy market and only take action to protect profit in periods of Class A divergence.
Primary Types of Technical Divergence
The two main types of technical divergence are bullish divergence and bearish divergence. Bullish divergence occurs when the price of an asset forms lower lows while the corresponding technical indicator forms higher lows. This discrepancy suggests that although the price is weakening, the momentum behind the downward movement is declining, indicating potential exhaustion among sellers.
Alternatively, bearish divergence occurs when the price of an asset forms higher highs while the technical indicator forms lower highs. Although the price is rising, the momentum behind the upward movement is diminishing, indicating potential exhaustion among buyers. Bearish divergence typically foreshadows downward price reversals, suggesting a possible selling opportunity for traders looking to capitalize on the impending downtrend.
One key difference between bullish and bearish divergence lies in their implications for market sentiment. Bullish divergence indicates a weakening of selling pressure, while bearish divergence signifies a diminishing buying interest and a potential shift towards selling pressure. In addition, the two differ in the timing of entry and exit points for trades. Bullish divergence often provides early signals of potential trend reversals, while bearish divergence can serve as an early warning sign of impending downward reversals.
How to Identify Technical Divergence
Identifying divergence in stock charts is a fundamental skill for traders and investors looking to anticipate price changes. To identify divergence in stock charts, traders typically start by analyzing the price action of the asset. They look for higher highs or lower lows in the price movement. As they do this, traders look at corresponding movements of a chosen technical indicator, focusing on whether it confirms or contradicts the price trend.
Once the price trend is established, traders then compare it with the behavior of the selected technical indicator. The two outcomes are bullish divergence or bearish divergence (discussed in the last section). Traders usually (or at least should) confirm divergence signals with other technical analysis tools and market indicators to gain confidence in the trading signal.
Short-term traders may use divergence signals to identify potential intraday or swing trading opportunities, while long-term traders may use them to identify trends and reversals over longer timeframes.
Hidden Technical Divergence
Hidden divergence is a lesser-known but powerful concept in technical analysis that involves a discrepancy between the direction of price movement and the direction of a technical indicator. This indicates a continuation of the existing trend rather than a reversal. Unlike traditional divergence, where the indicator moves opposite to the price, hidden divergence occurs when the indicator aligns with the price trend, but the underlying momentum differs.
Just like traditional divergence, there are two main types of hidden divergence: bullish hidden divergence and bearish hidden divergence. Bullish hidden divergence occurs when the price forms higher lows while the indicator forms lower lows, while bearish hidden divergence occurs when the price forms lower highs while the indicator forms higher highs.
Hidden divergence signals are particularly valuable for traders as they provide early indications of trend continuation. This phenomenon suggests that while the price may exhibit temporary pullbacks or rebounds, the underlying momentum supporting the trend remains intact. Therefore, understanding hidden divergence empowers traders to better interpret market dynamics to make better trading decisions.
Limitations of Technical Divergence
It's worth pointing out that technical divergence has its downsides. This list is not meant to be exhaustive, and some of those key limitations include:
- False Signals: Technical divergence, like any other trading signal, is not infallible and can occasionally produce false signals. During periods of low liquidity or high volatility, the reliability of divergence can be low, meaning traders can make wrong decision when relying on trading data.
- Lagging Indicators: Divergence signals are typically lagging indicators, meaning they may not provide timely alerts of trend reversals. By the time a divergence signal becomes evident, the market may have already made a significant move. This means traders would have missed out on the trade by the time they're able to receive and analyze the data.
- Subjectivity: Like most forms of analysis identifying divergence requires subjective interpretation as it involves comparing price movements with technical indicators. Different traders may interpret divergence signals differently, meaning there can be some inconsistent trading outcomes.
- Market Noise: Market noise and random price fluctuations can obscure genuine divergence signals. During periods of heightened volatility or news-driven events, divergence signals may become less reliable, leading to increased uncertainty in trading decisions.
- Confirmation Bias: Traders may exhibit confirmation bias by selectively focusing on divergence signals that support their existing biases or preconceived notions about market direction.
- Overbought/Oversold Conditions: Divergence signals indicating overbought or oversold conditions may persist for extended periods before price reversals occur. Traders relying solely on these signals may enter or exit positions prematurely, meaning, once again, they miss out on potential profits or incurring unnecessary losses.
An Example of Technical Divergence
The security shown in the chart below is experiencing a prolonged uptrend; an observant trader would realize that the price ROC is sloping down while the price continues to climb.
This type of negative divergence can be an early sign that the price of the underlying security may be reversing. If the price of the security breaks below the upward trendline, this will complete the confirmation and the trader will take a short position.
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How Can I Identify Divergence on a Price Chart?
Divergence can be identified by visually comparing the price movement of an asset with the movement of a chosen technical indicator, such as the Relative Strength Index or Moving Average Convergence Divergence. Divergence is typically indicated by diverging trendlines on the price chart and the indicator chart.
What Are the Differences Between Bullish and Bearish Divergence?
Bullish divergence occurs when the price makes lower lows while the indicator makes higher lows, signaling potential buying pressure. Bearish divergence occurs when the price makes higher highs while the indicator makes lower highs, signaling potential selling pressure.
What Are the Common Mistakes to Avoid When Trading Divergence?
Common mistakes when trading divergence include relying solely on divergence signals without confirmation, ignoring other factors that may influence price movements, and misinterpreting divergence patterns. These types of mistakes can happen with essentially any form of technical analysis.
How Does Volume Confirm Divergence Signals?
Volume can confirm divergence signals by indicating the strength and conviction behind price movements. High volume during divergence signals strengthens the reliability of the signal, while low volume may indicate weaker market sentiment.
The Bottom Line
Technical divergence refers to a phenomenon in technical analysis where the price movement of an asset diverges from the movement of a chosen technical indicator. It is often used by traders to identify potential trend reversals or continuations in the market.
