Working Divergence

If you questioned a sample of share and derivative traders on their thoughts on divergence you would receive a variety of answers, ranging from enthusiasm to disbelief. However divergence has been examined at length and many trading systems have been designed based on divergences alone with some degree of success.

What is it?
Divergence is a comparison of price to technical indicators. Divergence occurs when the indicator you are examining is moving in opposite direction to the price of the underlying share or index. It is as simple as that and can also apply to nearly all financial instruments.

Why doesn't everybody use it?
Divergence can indicate an imminent change in trend, a change of trend that is happening now or that a trend should continue. The vagueness is the problem. In doesn't necessarily mean a change in the direction of the share price, or if there is a change, it may only be a short-term change. A divergence signal suggests 'watching' for a trading opportunity in the direction of the signal. Divergences may continue over many swing cycles (highs/lows) so price action should confirm your trade.

Why the Popularity?
It can be used with many indicators including Stochastic, Moving Average Convergence Divergence (MACD), and RSI to name a few. Divergence also applies to the 'market-neutral' trading strategy of pairs trading.

Most traders or investors use divergence as some form of a warning system. Divergences can tell you two obvious things about possible market conditions. Firstly, that the trend could be coming to an end, or secondly, that the current trend may be continuing and it may be possible to continue for a long term trade. BHP late 2004 / early 2005 springs to mind. BHP's trend showed various divergence signals over that time however, the underlying trend was the dominating factor, so the savvy trader waited to ride the upside.

The Trap.
Many traders may believe too strongly in the concept of divergence and may see it as the end (or reversal) of the prevailing market or stock trend. However there are times when market sentiment and momentum are too strong and the market continues to reach relative highs or lows. Therefore when corrections to momentum and price happen they are usually short and sharp. After these brief respites the market may then be ready to resume its normal upward or downward trend. With each successive new high or low and for every divergence pattern that is formed, there are many nervous traders eager to believe in a top, bottom and reversal of trend. It must be remembered that there are markets that historically trend strongly and it is possible that they can develop multiple divergences which only lead to corrections of the overbought (or oversold) condition of the market.

Practical Example: Bearish Divergence Using RSI

We will be looking at the share price of Resmed (RMD) from early January to mid February 2007. The chart below highlights the share price movement of RMD and the Relative Strength Index (RSI) indicator. Click here for a further explanation of RSI.

As can be see from the above daily chart, the share price "peaks", shown in yellow and grey, experienced an increase in value, whilst the corresponding peaks in the RSI indicator (lower part of the chart), again circled in yellow and grey, were visually lower. This divergence is bearish. In this example, the share price gapped down the following day and reversed the previous short-term uptrend.

"If a trader attempted to go long or short with technical analysis based solely on divergences, they would need very deep pockets and would in all likelihood eventually exhaust their trading capital"

To be successful a trader must have the ability to quickly recognise a trend change, reverse their position and be able to trade in the direction of that new trend. Divergence is a useful tool that is particularly useful for CFD and Option traders. However, it should be used in combination with other tools, including fundamental and technical analysis, and some 'hands on' experience.

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