Can you teach me divergence tading?
That’s one of the recent questions I received. While I can’t really present a full lecture on divergence trading in a blog post, I can at least explain the concept here.
First, let me define the subject. Divergences are situations where two related things which generally would be expected to operate in tandem are not doing so. What those things are can vary considerably. It could be two stocks, currency pairs, commodities, or indices. It could also be two indicators, or price and an indicator.
The basic idea of divergences is that there’s something amiss. If, for example, the Dow is making new highs and the S&P is not, then the implication is that there’s some underlying weakness in the market preventing the broader index from moving higher. That would be considered a negative divergence. Reverse the situtation and you would have a positive divergence.
This Apple Computer (AAPL)Â chart show an example of a divergence between price and an indicator. In this case I have plotted the Relative Strength Indicator (RSI) on the chart. You can see how RSI put in lower highs at a time when AAPL was making higher highs. That would be a bearish divergence in that the indicator was showing a weakness that wasn’t showing up in the stock price action. The idea there is that eventually the two would have to come back in line.
Obvserving divergences can be helpful in your market analysis, but they can be a bit tricky in terms of trading. That’s because divergences can go on for long periods of time. If you were to jump on them when they first show up, in many cases the market would run you over as it continued on its merry way as if nothing was wrong. Apple is a perfect example of that. The market rallied considerably during the period when the divergence was showing. It did eventually roll over for a while, but it definitely would have been a very difficult short trade.
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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
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