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.)

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