Divergence

Divergence

What is a Divergence?

Interpretation in different market phases common mistakes

Divergences

• When prices and indicators move in the same direction, then are “in line”
  • The price trend is likely to continue
  • There is NO divergence
• When the indicator moves in a different direction to price then BEWARE – the indicator and price trend and Diverging
  • The divergence indicates that the velocity of the advance or decline is decelerating.
  • The prevailing trend MAY be about to reverse.
  • Can the trend velocity increase again?

Negative / Bearish Divergence

• Price – return line
• Momentum – Indicator Trend

• In an Uptrend:
  • The Up Trend Line connects the Bottoms of Price Action, BUT when checking for Divergences, you should connect the TOPS of an Up Trend.
• In a Downtrend:
  • The Down Trend Line connects the Tops of Price Action, BUT when checking for Divergences, you should connect the BOTTOMS of an Down Trend.

Positive / Bullish Divergence

• Price
• Momentum

In Divergence

Observing the momentum so that something going to happen in the price.

Divergence Strength: Points to note…

• Point A – point of maximum velocity of the price.
• Points B & C – price continues to rise (or fall) but at a slower pace.
• Divergence – the conflict between price and momentum (i.e. velocity of price)
  • Rising or Falling prices are supported by weaker momentum
  • Deterioration in Momentum is an early warning of weakness in the price trend itself!

Divergence Strength:

• Greater the Negative Divergence:

Greatermeans – the longer durations of the trend (How many Tops & Bottoms.)

• Fewer informed investors are buying while more of the uninformed buyers move in – Distribution? – when the weak buyers also start to sell then sharper the fall.

• Greater the Positive Divergence:
  • More and more informed investors are buying – Accumulation? – when the uninformed move in the price rise is mostly to be faster.
• Most mkt bottoms have at least one Positive Divergence
  • If the market is reaching a bottom and one does not see a positive Divergence then may be the market is NOT bottoming!
  • The above does not necessarily apply for tops.

Divergence Strength: Number of Divergences

• Greater numbers are indicative of longer & more significant weakening of the underlying trend (esp at mkt tops)
• When the confirmation (something happened in the ‘Price’) occurs, the reversal is likely to be sharper and faster.

Divergence Strength:

Most Recent Divergence around Equilibrium…

• Closer the last point of the Indicator is to be Zero level the more significant the Divergence.
• Mid point cent----
  • Negative Divergence: point C is at / below the midpoint of the indicator.
  • Positive Divergence: point C is at / above the midpoint of the indicator.
• Refer to the charts on Pos & Neg Divergence,

Divergence Strength:

Time between divergence

• Greater the time gap between the price and momentum (indicator) greater the significance.
• Keep in mind the time frame one is looking at: short – Intermediate – long term?
  • Short time frame settings have importance for the subsequent intermediate trend.
  • Intermediate time frame settings are important for the next primary.
  • When comparing peaks and bottoms of an indicator then compare like time frames. (Comparing the peak / bottom of a short time frame with an intermediate time frame indicator is wrong!)

Confirmed Divergence

• Divergences on their own do NOT signal a price trend reversal
• When Price Reversal signal is formed then any pre-existing divergence is said to be Confirmed.
  • Egs of price reversal: Trendline break, MA Crossover, Price pattern completion, etc.
  • Until the price reversal happened then it is a “Tentative Divergence”.

Divergence Trap

• A Point where price reversal is expected
• Price eventually breaks down and initial divergence is confirmed
• Indicator moves to a level higher than the previous one or more tops.

Divergence Trap

• A trader who is not aware of Divergence Trap will give up on his bearish view at Point A – where a fresh rally starts (and is also likely to be confused about divergences!)
• Eventually the confirmation happens and the price reverses.
• Exercise: Draw the Bullish Divergence Trap.

To check the strength of the Divergence check with the shorter, medium, longer and in all the three then it is more evidence.

Complex Divergences

• Price trends are determined by Interaction of many different time frames.
• Indicators look at only one time frame.
• Good practice to have 2 (or more) different indicators with different time settings.
• Various scenarios can occur with such a study.

Complex Divergences

• Price and indicators more in same direction – a very healthy trend.
• Shorter time cycle indicator peaks and falls while the longer time cycle one continues to rise – cycles are out of important sync – beware!
• Both indicators show divergences – body of evidence of a price reversal is stronger.
• Always wait for confirmation with price trend reversal.

All reversal does not / need not to come with the Divergence

Complex Divergences

• Ensure that the different time cycles are separated properly. Eg 10d vs 20d is fine but 10 vs 12 is not.
• Longer term indicator should be peaking when shorter term indicator is close to equilibrium point –
• Exercise: Illustrate Complex Divergence at tops and bottoms.

Strong Momentum BUT Weak Price

• Price
• Strong momentum BUT respectively weak price move
• Momentum
• Sign of a mature trend – May not he a aggressive reversals.

Divergences.

Common Errors…

• Divergences can be misleading in a strong trend.
  • Many (mild) bearish divergences before a price top materializes in a strong uptrend.
  • Many (mild) bullish divergences before a price bottom forms in a strong downtrend.
  • Alternative Interpretation of this…
• Getting too excited about divergences.
• Always confirm with a Price Reversal!