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 are common trading strategies when identifying divergence of indicators on a ...

    Learn some of the principle strategies traders can employ after spotting a divergence between technical indicators on a price ...
  2. How do traders identify confirmation of prices on a chart?

    Learn about some of the crucial tools that traders can use to confirm their price movements on a chart before entering or ...
  3. What is a common strategy traders implement when using the Parabolic Indicator?

    Learn a simple trading strategy designed for use with the parabolic SAR indicator, and understand the purpose for which the ...
  4. What are the best technical indicators to complement the Parabolic Indicator?

    Learn about two of the best technical indicators recommended for traders to use to refine a trading strategy based on the ...
RELATED TERMS
  1. Appraised Equity Capital

    The excess of the market value of an asset over its book value. ...
  2. Asset Valuation Review (AVR)

    A process that establishes an estimate of the value of a failed ...
  3. Derived Investment Value (DIV)

    A valuation methodology used to calculate the present value of ...
  4. Forex Spread Betting

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

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

    A momentum indicator that uses a stock’s price and volume to ...

You May Also Like

Related Articles
  1. Forex Strategies

    How to Build A Forex Trading Model

  2. Trading Strategies

    Not All Online Trading Brokers Are Created ...

  3. Trading Strategies

    Novice Trading Strategies

  4. Trading Systems & Software

    The Best Technical Analysis Trading ...

  5. Trading Strategies

    Is the Stock Correlation Strategy Effective?

Trading Center