What is Divergence
Divergence occurs when the stock price and another key indicator move in opposite directions on a chart. Divergence can be an indication of an imminent positive or negative price move.
Breaking Down Divergence
Divergence in technical analysis may signal a major positive or negative price move. Positive divergence occurs when the price of a security makes a new low while a key indicator such as money flow or volume starts to climb. Conversely, negative divergence is seen when the price makes a new high but the indicator being followed closes lower.
Traders use divergence to assess the underlying momentum of a stock price when determining the likelihood of a price reversal. For example, investors can plot oscillators such as momentum and volume on a chart along with the price of the stock. In the case of a stock with a rising price on a chart but oscillators trending downward, an investor may interpret this as a weakening sign in price movement. In this example, negative divergence will show on the chart and an investor should look for confirmation on a chart using other indicators to assist in making buy and sell decisions.
The opposite situation applies for positive divergence. In this case, the price of a stock would make new lows while the relative strength index (RSI) makes higher lows with each swing in the stock price. Investors may conclude that the lower lows of the stock price are losing their downward momentum and a trend reversal may soon follow.
Most indicators used in technical analysis provide three types of trading signals: crossing over a center line, crossing over a major signal line and divergence. Divergence is one of the most complex signals and one that can give less experienced investors false signals.
As is true with all forms of technical analysis, investors should use a combination of indicators to confirm a trend reversal before changing strategy. Traders can easily misread divergence given that oscillators can be very difficult to detect and may send misleading signals. Oscillators and other charting tools perform best when used during times of relative price stability, such as when a stock trades within its historical support levels and recent highs. During a prolonged bull or bear market, in which larger economic forces may be disproportionately significant in driving prices, divergence may not be as reliable. Seasoned investors know to balance their focus on short-term charting trends with the underlying fundamentals of a stock and the economy before making trading decisions.