The term divergence is often used when talking about technical analysis and indicators. Divergence is an occasion when the asset price moves in one direction, while the indicator shows an opposite signal. This phenomenon may confuse some traders. However, more experienced traders know that it might be helpful and may sometimes serve as an indication on its own. So, what is divergence? Let’s look at this phenomenon, explore why it happens, and how it might be potentially used in trading.
When does divergence in trading happen?
This term is used when the price is moving in the opposite direction than the oscillator. This can happen with any oscillator, regardless of the type that a trader may be using. The most popular oscillators are RSI, MACD, Stochastic – and they work well, but there is no indicator that could guarantee 100% accurate signals and that is why it is important to understand the divergence concept.
Divergence occurs when the asset and the indicator demonstrate a difference in the movement. There can be a positive and a negative divergence.
- Positive divergence occurs when the asset price drops, while the indicator shows a higher value. This could mean that there is a possibility of the asset price moving higher.
- Negative divergence is when the asset makes a new high, but the indicator demonstrates a lower high. In such a case, there is a possibility that a move lower in the asset may occur.
In the example of positive divergence above, it is noticeable that the price continues dropping and forms a lower low, while RSI shows the opposite. This indicates that the downward trend on EUR\USD is losing its strength.
The opposite of divergence is convergence – when the indicator and the asset are moving in the same direction and the indicator confirms the movement of the price. Ideally, that is what the trader wants as it confirms the strength of the trend. When both the asset price and the oscillator move alongside one another, it is a sign of the continuation of the market and normal conditions on it.
What does divergence tell you?
Divergence in trading may indicate that the current price trend may be weakening and may soon lead to a reversal. It indicates the lack of momentum for the asset. Divergence may be a sign of a potential opportunity for a new deal. Or it could signal the necessity of setting a stop loss level for a trade.
In certain cases, when a positive divergence occurs, it might be a sign that the trend is reversing upwards and that the price will soon rise. Negative divergence, on the other hand, may mean that the upward trend is losing strength and soon the price might fall.
However, it is important to understand that divergence should not be relied on exclusively. Though it may indicate that there might be a possibility of a trend reversal, it does not provide timely signals. It can last a long time and if the price does not go in the indicated direction, it may lead to substantial losses.
Divergence in trading does not always mean trend reversal, it is merely a reflection of the strength or weakness of the trend. So traders need to implement all the necessary risk management tools and double check all the signals they might receive from an oscillator. Another important thing to remember is that divergences are not very common, and they do not happen for every trend reversal. That is why mastering these kinds of signs may take time.
