Divergence vs. Convergence An Overview
Convergence generally means coming together, while divergence generally means moving apart. In the world of finance and trading, convergence and divergence are terms used to describe the directional relationship of two trends, prices, or indicators.
Most traders refer to a convergence when describing the price action of a futures contract. Here, convergence describes the phenomenon of the futures price and the cash price of the underlying commodity moving closer together over time. Convergence happens because, theoretically, an efficient market will not allow something to trade for two prices at the same time. The actual market value of a futures contract is lower than the contract price at issue because traders have to factor for the time value of the security. As the expiration date on the contract approaches, the premium on the time value shrinks and the two prices converge. If the prices did not converge, traders would take advantage of the price difference to make a quick profit. This would continue until prices converged.
When prices do not converge, there is an opportunity for arbitrage. Arbitrage is when an asset is bought and sold at the same time, in different markets, to take advantage of a temporary price difference. Arbitrage takes advantage of inefficiencies in the market.
In technical analysis, however, convergence occurs when the price of an asset, indicator, or index moves in the same direction as a related asset, indicator, or index. For example, there is convergence when the Dow Jones Industrial Average gains at the same time that its accumulation/distribution line is increasing.
[Important: Technical analysis focuses on patterns of price movements, trading signals, and various other analytical signals to inform trades, as opposed to fundamental analysis, which tries to find an asset's intrinsic value.]
Divergence is the opposite of convergence. When the value of an asset, indicator, or index moves, the related asset, indicator, or index moves in the other direction. Divergence warns that the current price trend may be weakening, and in some cases may lead to the price changing direction.
Technical traders are much more concerned with divergence than convergence, largely because convergence is assumed in a normal market. Divergence is interpreted to mean that a trend is weak or potentially unsustainable. Traders us divergence to get a read on the underlying momentum of an asset.
Divergence can be positive or negative. For example, a positive divergence would occur if a stock is nearing a low but its indicators start to rally. This would be a sign of trend reversal, potentially opening up an entry opportunity for the trader.
When divergence does occur, it does not mean the price will reverse or that a reversal will occur soon. Divergence can last a long time, so acting on it alone could be mean substantial losses if the price does not react as expected.
- Convergence is when the price of an asset and an indicator move toward each other.
- The absence of convergence is an opportunity for arbitrage.
- Divergence is when the price of an asset and an indicator move away from each other.
- Technical traders are more interested in divergence as a signal to trade.