Divergence

Definition

Divergence refers to the scenario in technical analysis where the price of an asset moves in a direction opposite to a technical indicator, signaling potential changes in trend. This discrepancy can indicate a weakening momentum of the current trend, suggesting that a reversal or correction may be imminent. Understanding divergence is essential for traders as it helps them make informed decisions based on price movements and indicator behavior.

5 Must Know Facts For Your Next Test

1. There are two types of divergence: regular divergence and hidden divergence, each providing different signals regarding market trends.
2. Regular divergence indicates potential trend reversals, while hidden divergence suggests that the current trend is likely to continue.
3. Divergence can occur on various timeframes, making it useful for both short-term traders and long-term investors.
4. Traders often combine divergence analysis with other technical indicators to increase the accuracy of their trading decisions.
5. Market psychology plays a crucial role in divergence; when prices rise but indicators fall, it may reflect underlying weakness that could lead to a price drop.

Review Questions

• How does divergence signal potential changes in market trends?
  • Divergence signals potential changes in market trends by highlighting discrepancies between price movements and technical indicators. When the price of an asset increases while an indicator like the RSI decreases, it suggests weakening momentum and may indicate that a reversal is near. This can alert traders to consider adjusting their strategies, as the current trend may not be sustainable.
• Compare and contrast regular divergence and hidden divergence in terms of their implications for traders.
  • Regular divergence indicates a possible reversal in the current trend, as it suggests that despite price movements favoring one direction, the underlying momentum is weakening. In contrast, hidden divergence suggests that the existing trend is likely to continue because it reflects strong underlying momentum. Traders can use these distinctions to tailor their strategies; for example, they might look for entry points during regular divergence for potential reversals while staying with positions during hidden divergence.
• Evaluate the effectiveness of using divergence as a trading strategy in combination with other indicators.
  • Using divergence as a trading strategy can be highly effective when combined with other indicators like MACD or moving averages. This multi-faceted approach allows traders to confirm signals before entering trades, reducing the likelihood of false positives. For example, if both divergence and a bearish crossover in MACD occur simultaneously, it strengthens the case for a potential downtrend, providing traders with higher confidence in their decisions.

Related terms

Convergence: Convergence occurs when both the price of an asset and a technical indicator move in the same direction, often reinforcing the current trend.

Relative Strength Index (RSI):

RSI is a momentum oscillator that measures the speed and change of price movements, often used to identify overbought or oversold conditions in an asset.

Moving Average Convergence Divergence (MACD):

MACD is a trend-following momentum indicator that shows the relationship between two moving averages of an asset's price, helping to identify potential buy and sell signals.