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Divergence

Chandrashekar Senthil Kumar
16/04/2020 0 0

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!
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