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What is ‘Divergence’ Divergence appears on a bar chart when the price of an asset and an indicator, index or other related asset move in opposite directions. In technical analysis, divergence is considered to be positive or negative. Either direction is a signal of a major shift in the direction of the price. Positive divergence occurs when the price of a security makes a new low while the indicator starts to climb.
Interpreting Divergence Divergence is usually associated with oscillator indicators. The calculation for oscillators takes various factors into account. For example, the Chaikin oscillator, takes the trading volume of the underlying security into account. Chaikin indicator makes lower highs with each price swing, traders can conclude that the higher highs for price are being made with decreasing volume, signaling a potential reversal to the downside. The inverse holds true for positive divergence.
RSI makes higher lows with each price swing, traders can conclude that the lower lows for price are being made with less and less momentum, signaling a potential reversal to the upside. Misinterpreting Divergence Trading signals derived from divergence that are based on oscillator indicators can be difficult to read, and they are sometimes misleading. When the market is in a strong trend in either direction, oscillators do not function well. Any signs of divergence during a strong trend would be ambiguous at best. Divergence is best suited for confirming market moves and should be used in conjunction with other technical indicators and fundamental analysis. D line highlights buying and selling pressure to confirm existing trends. What Does it Mean to Use Technical Divergence?
Divergence is definitely the most complicated indicator for the rookie technical trader. What are the most common divergence strategies implemented in forex trading? What are the best technical indicators to complement the Stochastic Oscillator? How do I read and interpret an Stochastic Oscillator? How do I start using technical analysis?
Our network of expert financial advisors field questions from our community. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. A celebration of the 100 most influential advisors and their contributions to critical conversations on finance. The latest markets news, real time quotes, financials and more. 1979 by Gerald Appel, is one of the most popular technical indicators in trading. The MACD is appreciated by traders the world over for its simplicity and flexibility, as it can be used either as a trend or momentum indicator.
MACD: An Overview The concept behind the MACD is fairly straightforward. Of the two moving averages that make up the MACD, the 12-day EMA is obviously the faster one, while the 26-day is slower. The MACD histogram is an elegant visual representation of the difference between the MACD and its nine-day EMA. The histogram is positive when the MACD is above its nine-day EMA and negative when the MACD is below its nine-day EMA. If prices are rising, the histogram grows larger as the speed of the price movement accelerates, and contracts as price movement decelerates.
The same principle works in reverse as prices are falling. Figure 1 is a good example of a MACD histogram in action. The MACD histogram is the main reason why so many traders rely on this indicator to measure momentum, because it responds to the speed of price movement. Indeed, most traders use the MACD indicator more frequently to gauge the strength of the price move than to determine the direction of a trend. Trading Divergence As we mentioned earlier, trading divergence is a classic way in which the MACD histogram is used. One of the most common setups is to find chart points at which price makes a new swing high or a new swing low, but the MACD histogram does not, indicating a divergence between price and momentum.
Figure 2 illustrates a typical divergence trade. At the right-hand circle on the price chart, the price movements make a new swing high, but at the corresponding circled point on the MACD histogram, the MACD histogram is unable to exceed its previous high of 0. The histogram reached this high at the point indicated by the lower left-hand circle. Unfortunately, the divergence trade is not very accurate, as it fails more times than it succeeds.
Prices frequently have several final bursts up or down that trigger stops and force traders out of position just before the move actually makes a sustained turn and the trade becomes profitable. Figure 3 demonstrates a typical divergence fakeout, which has frustrated scores of traders over the years. Figure 3: A typical divergence fakeout. One of the reasons traders often lose with this setup is that they enter a trade on a signal from the MACD indicator but exit it based on the move in price. Since the MACD histogram is a derivative of price and is not price itself, this approach is, in effect, the trading version of mixing apples and oranges.
Using the MACD Histogram for Both Entry and Exit To resolve the inconsistency between entry and exit, a trader can use the MACD histogram for both trade entry and trade exit signals. Currency traders are uniquely positioned to take advantage of this strategy, because the larger the position, the larger the potential gains once the price reverses. In effect, this strategy requires the trader to average up as prices temporarily move against him or her. This is typically not considered a good strategy. Many trading books have derisively dubbed such a technique as “adding to your losers.