Divergence is a stock exchange term for the disagreement in the movement of indicator values and price charts. It warns traders of a slowdown or trend reversal.
What is divergence?
A divergence is a technical analysis signal of a possible trend change that can be detected by an indicator. It is a divergence between the price of an exchange-traded asset and the indicator value.
In order to correctly assess the signal, at least two extrema on the price chart and two on the indicator should be taken. They should be found below each other. Some traders consider divergence to be one of the strongest signals in technical analysis.
Types of divergence
- Bullish divergence (positive divergence) – implies a rapid rise in price - occurs when the value of a financial instrument declines and the indicator rises. This type of divergence is also called convergence
- Bearish divergence (negative) – suggests that the price is about to drop – occurs when the price of a financial instrument is rising, and the indicator values are moving down
For more information on Divergence and Convergence, refer to "Divergence and Convergence in Trading: How to Use Signals".
Which indicator shows divergence
Any oscillator - such as the RSI indicator or the Stochastic Oscillator – can be used to find divergences. However, investors most often look for divergence in the MACD indicator – this is the subject of the article "MACD Indicator: Settings, Trading, Divergence".
Traders evaluate the MACD histogram and price chart behaviour, and the zero line shows which divergence is likely to occur in the near future. If the indicator is above zero, a bearish divergence is expected; if it is below zero, a bullish divergence is to be expected.
Pros and cons of divergence
- Divergence is quite easy to find on the charts: simply compare two price peaks and similar peaks on the indicator chart
- Indicates the location of a possible trend reversal
- Allows for an entry point into the market, and traders use the reverse signal as an exit option
- It can be used as a standalone trading strategy, or in combination with other technical analysis tools
- Like any other technical analysis indicator, it could give false signals
- Not all market reversals will occur with the formation of a divergence
- To be more effective, auxiliary signals such as trendline breakdowns or reversal patterns should be used
- In a strong trend, several divergences might occur before the price chart reacts to the formation of this signal
- Predicts trend reversals, but not targets for further price movement