Divergence is when an asset moves against a technical indicator, such as an oscillator, or moves against other data. Divergences can lead to a possible current price trend and, in some cases, can cause a change in price direction.
Two types of Divergence:
- A positive divergence indicates a higher probability of the asset’s price movement.
- A negative divergence indicates that a move lower in the asset is possible.
Traders use divergences to assess the momentum of an asset’s price and the possibility of a price reversal. For example, investors can plot an oscillator on a price chart, such as the Relative Strength Index (RSI). If the asset rises and makes a new high, the RSI should ideally also hit a new high. If the asset makes new highs, the RSI starts making lower highs, but the uptrend in price may weaken. This is a negative divergence. Traders can then determine if they want to exit the position or set a stop loss if the price falls.
Positive Divergence is the opposite situation. Imagine the stock price is making new lows while the RSI is making higher lows with each swing in the stock price. Investors may conclude that lower lows are losing their downward momentum and a trend reversal is imminent.
Limitations of Using Divergence
As with all forms of technical analysis, investors should use a combination of indicators and analytical techniques to confirm trend reversals before acting solely on divergences. Differences will not exist for all price reversals. Therefore, some control or other risk analysis must be used with divergences.
Also, when a divergence occurs, it does not mean the price will reverse, or a reversal is imminent. Divergences can last long, so acting alone could mean significant losses if prices don’t react as expected.
