What is Divergence and How to Use It for Stock Trading

What is divergence

In mathematics divergence has a different meaning, but we shall purely discuss divergence in financial terms which is applicable to stocks, futures, forex, crypto or any other tradable assets that can be deployed in a chart pattern environment. Divergence has been used in trading for  quite some time and many successful traders have been applying it for decades to determine near term market moves. The best thing about divergence is, it indicates probable change in trade and along with a good risk reward ratio, you get a stoploss level also.

What is Divergence

Divergence is  said to happen when the price of  a stock, future, commodity or crypto is moving in the opposite direction than an applied technical indicator for the same period and timeframe.  For example, if price is moving up and RSI is going down, and RSI divergence is happening. Similarly, it may another indicator like MACD, On Balance Volume (OBV) and any oscillator.

What is divergence

Fig 1: In the chart above, price is moving down as indicated by the trendline, while RSI is not going down. In fact RSI reached a higher point at the corresponding lowest level of price, showing clear divergence.

Types of Divergence

There are primarily two types of divergences – Positive divergence and negative divergence. A positive divergence indicates that price should now be going up as per the divergence and negative divergence is reverse of positive and indicates probable down movement. Fig 1 above is type of positive divergence since it predicted the up reversal movement.

Negative RSI Divergence

Fig2: A negative divergence indicates probable down reversal. The above chart shows a clear negative divergence when price goes higher but RSI is coming down.

 

Divergence can also be classified as Classic Divergence and Hidden divergence. All discussed here are classic divergences. We’ll talk about Hidden Divergence later.

What does a divergence indicate?

A diversion, when happening indicates that the current trend sentiment is weakening and a reversal may happen.

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