Divergences

Divergences are frequently occurring patterns between market price and some indicator, usually an oscillator type indicator. They are used by traders to confirm potential lack of momentum in a recent market trend, and generally they can be used to determine whether an imminent price reversal will take place in the market. Divergences work well most of the time, in that they do detect these imminent reversals, but their timing is not accurate. They simply give off a warning signal that an up trend is losing momentum and will reverse into a down trend, at least for a while, but they cannot pinpoint the exact time that this will happen.

Traders use divergences together with other indicators and chart patterns, so quite often they are able to detect loss of momentum in the current market trend using divergences. And then look out for any other indicator or pattern to pinpoint the exact day where the trend reversal or correction will start.

Generally, the longer the time frame a divergence is occurring over, the more powerful and the more profound it will turn out to be in terms of changing the current market trend. Some divergences take time to form, as long as several weeks or months, while others only take days or hours. As traders zoom in on the charts, beyond daily charts, divergences occur far too often but many of them are proven wrong or meaningless. So in all cases the longer time frame divergence will override a an opposite divergence of shorter time frame.

As a result, divergences have been used by day traders, giving them mixed results. But they are far more powerful on longer time frames, they almost always impact the market in the expected direction. And as long as one can use more techniques in order to pinpoint the exact reversal day or week, then divergences can help traders avoid false trends and many potential losing trades.

In general, if given two different market charts, having seemingly identical trends but with one having a divergence, suggesting that a reversal is bound to happen, it becomes evident that price charts alone cannot tell traders the whole story. The trend that is losing momentum is well disguised and difficult to distinguish from a trend having strength, this is where the principle of divergence is so useful.

Most indicators are market price based oscillators, and some are price and volume based. Even the simplest price based ones can reveal amazing points in the market where something is bound to happen. And this happens only when one makes the comparison between market price and divergence. If there is no divergence at all, it means that the current market trend may continue or change, and the indicators will also change with it. So absence of divergence does not mean that there cannot be a reversal. But if a reasonable divergence is present, then it will almost certainly turn out to be right.

When in doubt, traders use inter-market analysis, longer time frames to confirm or disprove the presence of a suspected divergence. They also use multiple indicators known for detecting divergences. Such indicators for example might be oscillators such as the Relative Strength Index (RSI), or the Commodity Channel Index (CCI) and more. The trick here is that sometimes one indicator will correctly form a divergence, while the other won’t. In such cases a closer analysis is needed, one that ideally zooms out on the chart, over more markets, and also takes into account the status of two or more oscillators. If two oscillator indicators agree on the same time frame and markets, then very likely there is a valid divergence in the making, even though one or more of the oscillator indicators is showing no such divergence.

GBPUSD currency pair

The above chart shows the GBPUSD currency pair, with two oscillator indicators, RSI and CCI seen below. Notice how only one oscillator works at a time, in detecting a weakness or strength in the market, while the other oscillator remains passive. The first divergence in yellow shows a market that rises while the CCI reading is falling, the market ends up falling as a result. The next divergence in blue, is formed on the RSI oscillator, the oscillator gives off higher lows while the market gives off lower lows, the market ends up rallying as a result. That is how divergences work. Notice that you always need to compare market highs to oscillator highs, and market lows to oscillator lows!

Indicators and oscillator indicators are well connected to the market for about fifty percent of the time, while for the other fifty percent they are lagging behind as they are adjusting, especially when they are coming out of a phase where they did their job. Therefore indicators in general do not work in a continuous way, but rather work for a while, then ‘disconnect’ from the market and work passively, and then start working again and have predictive power. That’s why when two indicators disagree on divergence formation, one tends to show a clear divergence while the other shows no divergence. And this is the tricky part, because the indicator that perfectly mimics market price action and shows no divergence is usually the indicator in passive mode, the one that lags behind and is actually disconnected from the market.

All predictive power lies with the indicators that disagree with (hence diverge from) market price, that’s the whole point of looking out for divergences. As always, traders need to use chart patterns or more indicators to pinpoint the exact day or week where the divergence in question will be triggered and the market will react as a result. That pattern might be some trend line, the previous day’s range, or some other indicator. There is really no exact solution to this approach.

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