Divergence

Divergence is a situation in which new highs (lows) are formed on the price chart of the current trend, and the indicator does not follow the price or moves in the opposite direction. In trading, divergence is considered to be the strongest signal of indicator analysis since the divergence provides an important signal that the present price trend is beginning to weaken, and sometimes even changing the course of the price. A positive divergence alerts a trader about a probable upward trend in the asset price, while a negative one, on the contrary, indicates a very real downward price movement of this asset.

Explanation of Divergence

Divergence can appear between the asset price and almost any indicator, whether technical or fundamental.

In technical analysis, a divergence can act as a strong signal of a significant positive or negative price movement. If the price of a certain asset makes a new low, and an indicator such as money flow tends to rise, then it is the case of a positive divergence. Conversely, if the price reaches its new high, but the observed indicator shows a lower high, then a negative divergence happens. 

A positive divergence indicates a likely price jump in the near future. This situation appears if the price goes down and the technical indicator trends up or shows bullish signs. A negative divergence informs about a future price decline. This situation occurs if the price goes up and the technical indicator trends down or shows bearish signs.

Divergence is widely used in trading to assess two factors: the underlying momentum of an asset's price and this price reversal probability. Traders can display oscillators on the price chart, such as the Relative Strength Index (RSI). If the situation is ideal, with the price growth and reaching new highs, the RSI also tends to rise and goes up to new highs. 

However, the simultaneous formation of lower RSI highs and the achievement of new highs by stocks alerts that the price uptrend weakens, so, this case counts as a negative divergence. Analyzing a particular situation, the trader makes a decision to exit the position or place a stop loss just in case the price goes down. The opposite situation occurs in the case of positive divergence.

Divergence allows applying many technical indicators, mostly oscillators. 

Divergence vs Confirmation

Divergence is a phenomenon in which the price and indicator give the trader different signals. 

Confirmation is a phenomenon in which both the price and several indicators inform him about the arising situation with the help of similar signals. This process is of great importance for the trader because it affects the moment of entry into the transaction and the time of exit from it. If the price tends to rise, the trader wants to get confirmation from these indicators that this growth will be continued further.

Divergence limitations

To be sure that the trend is accurately reversing, a trader should rely not only on divergence, but also apply a wide combination of indicators and other methods of technical analysis. Divergence may not be present in absolutely all cases of price reversal, which is why it is so important to use another form of risk control in combination with it.

In addition to this, it does not follow from the occurrence of a divergence that the price will necessarily reverse in the near future. The duration of the divergence can be very long, so making a decision solely on it can bring significant losses to the trader if the price reaction turns out to be different from the expected one.