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:
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.
Understanding divergence, however, can lead to the most profitable trades, because it helps the trader recognize and respond to changes in price action. It signals that something is changing and the trader should consider his options, whether that is to sell a covered call or tightening a stop. The problem comes when the ego gets in the way of making a profitable trade—you must take the correct action based on what the price divergence is actually doing, not what you think it may do in the future.
Divergences tend to be either bullish or bearish and are classified by strength. A Class A divergence is stronger than a Class B and a Class C divergence is the weakest of them all. Experienced traders tend to ignore Class B and Class C divergences as simply indicators of a choppy market and only take action to protect profit in periods of Class A divergence. (See also: Bullish Divergences and Bearish Reversal Signals.)