In the arena of technical analysis, the term divergence refers to the developing separation between a financial instrument's current market price and a related indicator or product. At its core, divergence addresses the relationship between the momentum of price action and the behaviour exhibited by a correlated asset, index or other indicator.
Typically, divergence is identified through visual examination of the ongoing relationship between a security's market price and a predetermined oscillator. This is accomplished by actively comparing charting data side-by-side, or through the use of a chart overlay. Common oscillators used by traders and investors are stochastics, MACD, RSI and moving averages.
The origins of divergence can be traced to the writings of Charles Dow and the subsequent development of Dow Theory. Included in Dow Theory is an examination of the interrelationship involving the Dow Jones Industrial Average (DJIA) and the Dow Jones Transportation Average (DJTA).
The theory states that when one of the two averages climb to a new high, then the other is expected to exhibit the same characteristics. For instance, if the DJIA makes a new yearly high, then the DJTA is expected to make its own yearly high in short order. In the event that it does not, then the two indices are showing divergence, a sign of a possible change in market direction.
Types Of Divergence
There are two types of divergence: regular and hidden. In addition, each type can be classified as either bullish or bearish (positive or negative) depending upon its occurrence within the context of observed price action.
Regular divergence is the easiest to identify and can be a sign of market reversal. Essentially, price extends its overall range by making higher highs or lower lows while the correlated indicator contracts its range through making higher lows or lower highs.
For example, in the case of a downtrend, regular divergence is exhibited by price making lower lows but the related oscillator making higher lows. In this instance, the divergence is a signal that the downtrend is weakening and price may be ready to rebound.
Classifications of regular divergence:
- Bearish: Price establishes higher highs while the oscillator exhibits lower highs. This is an indication that buying pressure is subsiding.
- Bullish: Price achieves lower lows while the oscillator exhibits higher lows. This is an indication that selling pressure is decreasing.
Hidden divergence is more difficult to diagnose and can serve not only as a signal of trend reversal, but also of trend continuation. It's present when price does not extend its range, but the related oscillator does.
For instance, given the scenario of a strong uptrend, price tests the established intermediate top but doesn't extend to a new high while the oscillator achieves its own new high value. The failure for price to extend to a new high, coupled with the heightened momentum shown by the oscillator, is a sign of weakness and a possible market correction. This is an example of hidden divergence, because price failed to extend in the midst of substantial momentum illustrated by the oscillator.
Hidden divergence can be found during the retracement of a trend or at a test of market extremes. If present during a trend's retracement, it can signify a potential extension of price, while at market extremes it can be a sign of a pending reversal in price action.
Classifications of hidden divergence:
- Bearish: Occurs when price stays below the intermediate top but the oscillator establishes a new high value. This commonly occurs within the retracement of a downtrend or at a test of an established high.
- Bullish: If price can't fall below an established bottom, while the oscillator makes a new low, bullish hidden divergence is present. Typically, this scenario occurs during the retracement of an uptrend or at a test of a previous low.
It's important to remember that most trading approaches reliant upon divergence are based on correlations made between momentum oscillators and an individual security's price action. In the event that a security is in the midst of a strong trend, momentum oscillators can provide false counter-trend signals. Conversely, when a market enters a consolidation phase, the lack of sufficient price action may lead to a scarcity of clear-cut signals.
Being aware of the current market state is imperative to a trader incorporating divergence into his or her trading approach. Ultimately, divergence is best utilised as a tool for confirmation, and it should be used to make trading decisions in concert with other aspects of technical and fundamental analysis.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…