Divergence is a term used to reflect the directional relationship between two indicators, trends, or price actions. This is very pivotal in the domain of technical analysis. Signals given by most tools could come either as crossing over a major signal line, indicator divergence, and crossing over a major center line. Indicator divergence is arguably the most important, and justifiably so.
A divergence basically occurs when two trends move away from each other. The counterpart of a divergence is convergence, which occurs when two trends move towards each other. Convergence is typical of the efficient market, and is not usually a subject of focus for analysts. However, in situations where the market fails to converge, it is an opportunity for arbitrageurs to take action. In a divergent market, the price of an asset and technical indicators are moving in entirely different directions. The value of an asset, indicator, or index moves in a trending direction, but the related asset, indicator, or index moves in the other direction. This is usually a pointer to a weakening trend.
There are two types of divergence. A positive divergence or bullish divergence is when the price of an asset moves in the direction of a downtrend, but major indicators like the Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD) are moving upwards. In this situation, the asset price is hitting lows, but the indicators are bullish. This could signal a coming trend reversal and good buying opportunity for the trader. A negative divergence is the opposite of a positive divergence. The price of the asset is rallying in an uptrend, but the major indicators are headed downward in bearish pattern. This could also be a signal that the market is about to plunge into a downtrend in a coming reversal, and would be a good time for traders to secure profits. It is noteworthy however, that divergence can appear over a long timeframe. Hence, the fact that the market is divergent does not necessarily signal an immediate trend reversal. The reversal might not occur till much later, and market conditions might even change before then. Other tools like trendlines, support, and resistance could be used to confirm trend reversals predicted by divergence before acting on it.
Furthermore, divergences can also be classed by strength. The strongest type of divergence is a Class A Divergence, followed by a Class B Divergence, then the Class C Divergence. The most reliable is the Class A Divergence, and thus, traders often disregard Class B and Class C divergences because they might only be reacting to an intermittent market.
Divergences are mainly used to identify weak and unstable trends, and they can project the underlying momentum of an asset. This makes it a reliable oscillator in technical analysis indicators, and a fundamental part of TA. However, it is not definite enough to be used exclusively and could occasion heavy losses if not properly combined with other tools for confirmation.
