Divergence in Trading
Over the years, we’ve heard about using divergence in trading as a tool. Some of you may know what it is, some have heard about it but don’t really understand it, and some of you have no idea what it is.
Definition
Defining divergence is relatively simple with respect to trading. To break it down into its simplest components, divergence can be seen when the price of anything moves in the opposite direction than a technical indicator, usually an oscillator. We’ve drawn up examples for your reference.
We’ve seen the lines connecting tops instead of bottoms as noted in the illustration, but the basic concept states that if your price is making higher highs while the indicator makes lower lows (or the other way around), you have “divergence”.
What it Tries to Foretell
Divergence attempts to give traders advanced warning that the current trend may be weakening and a change in direction might be on the horizon. What it can’t do is tell you when. Divergence has no expiration date.
Does it Work?
You can definitely see it on the charts. In fact, there are indicators which have been coded to automatically highlight price/indicator divergence, so you don’t have to. It can work, and some traders use it as part of their strategy, so feel free to examine it. Learning about any aspect of trading is beneficial as an informed trader.
Let’s Go To The Videotape
We’ll point out a few examples and break down what is happening. Whether it “works” is a bit subjective due to its inherent nature. We’ll explain it through the use of pictures…because pictures are worth a thousand words, right?
Keep Me Guessing
In this example, we see what appears to be divergence forming to forecast price moving up. Do we anticipate going long here?
However, as we uncover more candles, price continues to fall and divergence grows. Now, should we get ready to jump in?
Okay, not yet. So we’ll wait. Third time is the charm, right? Look, price is starting to climb. Jump in with that long trade.
And look what happened. It went up just a bit to draw you and everybody else watching the same divergence, then price reverses and takes out your trade.
Reality Check
In reality, trying to anticipate when divergence indicates when to get in is a guessing game. Since we cannot know if price will follow the opposite of what is supposed to happen, it’s probably a better idea to wait and see what does happen and act accordingly…with techniques (such as using your algorithm) to signal entries and exits.
Remember, you don’t have a crystal ball and trying to outguess the market will only result in frustration and a dwindling bankroll.
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