Divergence Indicator
tl;dr
The Divergence Indicator is a technical tool used by traders to spot potential trend reversals by comparing price action with the movement of technical indicators like RSI, MACD, or Stochastic Oscillator. When the price and the indicator move in opposite directions, it signals that momentum is weakening and a reversal may occur. Traders use divergence to time entry and exit points, often in combination with other indicators for confirmation.
Definition.
A tool used to identify discrepancies between price movement and momentum indicators, often signaling a potential trend reversal. Pro tip: see RSI and MACD.
Real-World Example.
A Divergence Indicator is a technical analysis tool used by traders to spot divergence between price action and an indicator (like the Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), or Stochastic Oscillator). Divergence occurs when the price of an asset is moving in the opposite direction of an indicator, which can signal a potential trend reversal.
For example, let’s say Company ABC stock has been rising for weeks, but its RSI indicator has been showing lower highs during the same time. This is called bearish divergence, and it could signal that even though the price is going up, momentum is weakening, and the trend might reverse soon.
Conversely, if XYZ Corp‘s stock price is making new lows, but the MACD is showing higher lows, this would be a bullish divergence, indicating that the selling pressure may be losing strength and a reversal to the upside could be on the way.
How the Divergence Indicator Works.
- Types of Divergence:
- Bullish Divergence: This happens when the price makes a lower low, but the indicator (e.g., RSI, MACD) makes a higher low. It suggests that the downtrend may be losing momentum, and a reversal to the upside could be imminent.
- Bearish Divergence: This occurs when the price makes a higher high, but the indicator makes a lower high. It indicates that the uptrend may be weakening, and a reversal to the downside could be coming.
- Common Indicators for Divergence:
- RSI (Relative Strength Index): A common indicator used to spot divergence. If the RSI is showing a different pattern than the price (e.g., making higher highs while the price is making lower highs), it could signal that the trend is losing strength.
- MACD (Moving Average Convergence Divergence): A popular momentum indicator. Divergence occurs when the MACD line moves in the opposite direction of the price, indicating a potential trend reversal.
- Stochastic Oscillator: A momentum indicator that compares an asset’s closing price to its price range over a specific period. Divergence between the Stochastic Oscillator and the price can also signal a trend reversal.
- Why Divergence Happens:
- Divergence happens because price action is driven by the market psychology and supply and demand. When price moves in one direction but the indicator moves in the opposite direction, it suggests that the momentum behind the current trend is weakening, and a reversal might be likely.
How to Use the Divergence Indicator in Trading.
- Spot Trend Reversals:
- One of the most common uses of the Divergence Indicator is to predict trend reversals. For example, if a stock is in an uptrend and starts showing bearish divergence, it may be a sign that the uptrend is running out of steam, and a downturn is approaching. Conversely, bullish divergence can indicate that the downtrend may be about to end and a reversal to the upside is possible.
- Combine with Other Indicators:
- Divergence can be more reliable when used in conjunction with other technical indicators. For example, if you spot a bullish divergence on the RSI and also notice that the stock is near a key support level, this could be a stronger signal that the price is likely to reverse upward.
- Use Divergence for Entry and Exit Points:
- Traders use divergence to time their entry and exit points. For example, if a bearish divergence signals a reversal, a trader might exit their long position or open a short position. Similarly, a bullish divergence could signal the perfect time to enter a long position.
- Look for Confirmation:
- Divergence should not be relied upon solely for trade decisions. It’s important to look for confirmation from other indicators or price action before acting. For example, after spotting divergence, wait for a break of key support or resistance levels to confirm the reversal.
- Timeframe Consideration:
- Divergence can appear on multiple timeframes, but it’s often more reliable on longer timeframes. A divergence on the daily or weekly chart is usually stronger and more meaningful than one on the minute or hourly chart.
