Divergence appears on a bar chart when the price of an asset and an indicator, index or other related asset move in opposite directions. In technical analysis, traders make transaction decisions by identifying situations of divergence, where the price of a stock and a set of relevant indicators, such as the money flow index (MFI), are moving in opposite directions.
In technical analysis, divergence is considered to be positive or negative. Either direction is a signal of a major shift in the direction of the price. Positive divergence occurs when the price of a security makes a new low while the indicator starts to climb. Negative divergence happens when the price of the security makes a new high, but the indicator fails to do the same and instead closes lower than the previous high.
Divergence is usually associated with oscillator indicators. Oscillators measure the position of the current data for a specific factor (such as price, momentum or volume) relative to the total range of said factor for a specified number of historical bars on a bar chart. The calculation for oscillators takes various factors into account. A situation in which the calculation of an oscillator results in peaks that are trending lower, while the price action of the underlying security is exhibiting peaks that are making new highs with every price swing, indicates that each new high achieved by the underlying price is getting weaker in terms of the factor that is measured by the oscillator. On an appropriate price chart, a display of negative divergence will appear.
For example, the Chaikin oscillator, takes the trading volume of the underlying security into account. In a negative divergence situation (also referred to as bearish divergence), as price makes higher highs while the Chaikin indicator makes lower highs with each price swing, traders can conclude that the higher highs for price are being made with decreasing volume, signaling a potential reversal to the downside.
The inverse holds true for positive divergence. The relative strength index (RSI) takes into account the momentum of price action for the underlying security. In a positive divergence situation (also referred to as bullish divergence), as price makes lower lows while RSI makes higher lows with each price swing, traders can conclude that the lower lows for price are being made with less and less momentum, signaling a potential reversal to the upside.
Trading signals derived from divergence that are based on oscillator indicators can be difficult to read, and they are sometimes misleading. When the market is in a strong trend in either direction, oscillators do not function well. Any signs of divergence during a strong trend would be ambiguous at best. Divergence is best suited for confirming market moves and should be used in conjunction with other technical indicators and fundamental analysis.