Divergence happens when the direction of a price trend and the direction of an indicator move in opposite directions. Hence, divergence can be an indication of an approaching positive or negative price move.
Divergence in technical analysis tends to provide signals of either a major positive or negative price move. Positive divergence is observed when the price of a security tends to be at a new low whereas an indicator such as money flow or volume starts to rise. On the contrary, negative divergence happens when indicator closes at a lower level while the price seems to touch a new high.
Divergence is often used by traders to analyse the underlying momentum of stock while assessing whether the price is likely to reverse or not. For example, investors may place momentum and volume, the oscillators and the price of the stock on the chart. Thereafter, if the price of a stock is on rising but oscillators take the downward trend then this may imply as a weakening signal for price movement. Negative divergence will be shown in the chart and an investor with the help of other indicators to assess whether to buy or sell in the market.
The opposite situation of the above example would be a positive divergence. In that scenario, the price of a stock will be at new lows whereas, relative strength index touches higher lows with every swing in the price of the stock. Through this, investors may interpret that lower lows of the price of a stock are losing their downward momentum and may soon follow a trend reversal.
The trading signals provided by the indicators are crossing over a center line, crossing over a major signal line and divergence. Divergence is known to be one of the most complex signals.
Indicator divergence may happen over continued period of times. Hence, while using divergence, other tools such as trendlines, support and resistance levels can also be used to assess or confirm the reversal in making trading decisions.
When done understanding thoroughly divergence, it can lead to highly profitable trades as it assists traders to interpret the changes in price action and the chance to traders to respond to the same accordingly. The main concern is to act in the desired way to make a profit after getting signals by the divergence of whether to buy or sell the securities during a trading session.
Divergences are either bullish or bearish. These are hence classified on the basis of strength. There are 3 classes: Class A, Class B, and Class C. Class A divergence tend to be stronger than Class B divergence and Class C divergence is known to be the weakest out of three. Class A divergence periods are taken into consideration by traders to make profits and Class B and Class C divergences are usually ignored by the traders.
In technical analysis, it is always recommended to uses a combination of indicators so as to make the right decision by confirming the trend reversal. Investors should always take into account various tools before adhering to a strategy or changing a strategy. As it is known that oscillators may turn difficult to comprehend and may send false signals, divergences can be easily misread by the traders. Divergences may not act as a reliable tool during bull or bear market when larger economic forces tend to drive price movements.