What does it mean to use technical divergence in trading?

By Casey Murphy AAA
A:

In technical analysis, most indicators can give three different types of trading signals: crossing over a major signal line, crossing over a center line and indicator divergence.

Of these three signals, divergence is definitely the most complicated for the rookie trader. 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 - 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.

The chart below shows an example of divergence:

Ebay_NegDivergence.jpg
Chart by MetaStock

The security shown 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.

(For further reading, see Divergence, Momentum and Rate Of Change.)

RELATED FAQS

  1. What trends and data influence after-hours traders the most?

    Learn about the specific information that after-hours traders review to influence their trading.
  2. What are some common traits of undervalued stocks?

    There are a few basic factors found in companies that are worth more than their current stock price.
  3. What are the best indicators for evaluating technology stocks?

    Technology stocks are often some of the most discussed stocks on the news. How can investors spot the company that will roll ...
  4. What technical indicators can I use to find undervalued stock?

    Investors seeking new ideas may want to look to technical analysis to see whether the market has undervalued a particular ...
RELATED TERMS
  1. Forex Spread Betting

    A category of spread betting that involves taking a bet on the ...
  2. Mass Index

    A form of technical analysis that looks at the range between ...
  3. Money Flow Index - MFI

    A momentum indicator that uses a stock’s price and volume to ...
  4. On-Balance Volume (OBV)

    A momentum indicator that uses volume flow to predict changes ...
  5. Negative Volume Index - NVI

    A technical indicator that relies on changes in a security’s ...
  6. Accumulation/Distribution

    An indicator that tracks the relationship between volume and ...
comments powered by Disqus
Related Articles
  1. Simple Moving Averages Make Trends Stand ...
    Active Trading Fundamentals

    Simple Moving Averages Make Trends Stand ...

  2. Valuing Firms Using Present Value Of ...
    Fundamental Analysis

    Valuing Firms Using Present Value Of ...

  3. 10 Timeless Rules For Investors
    Active Trading Fundamentals

    10 Timeless Rules For Investors

  4. Preparing Your Finances From Natural ...
    Home & Auto

    Preparing Your Finances From Natural ...

  5. The Leap-Year Phenomenon
    Active Trading

    The Leap-Year Phenomenon

Trading Center