Option Investor
Educational Article

Divergence

HAVING TROUBLE PRINTING?
Printer friendly version

Buzz Lynn

Webster's Dictionary says, "To go or move in different directions; to differ, as in opinion". Sounds like CNBC Analyst de Jour's market opinion vs. my own - definitely different.

However, divergence isn't always about being bullish when everyone is bearish or vice-versa. It's not necessarily fundamentals-laden opinion either. For despite it's fundamental bent toward, well, fundamental opinions, it's a concept we use frequently in technical analysis too to help us decipher potential market direction. We use the term when looking at charts.

So just how does divergence work and how can we apply it to our charts for better interpretations of the market? Glad you asked! Today, we are going to stick to the meaning and definition of the word so that fellow readers can add this to their trading arsenal. Application is like anything else with a thousand different nuances, but today, it's important to understand what it is. Only then is it useful. And it's so simple, we almost don't even need an instruction manual!

OK, so back to, "What is it?". Divergence is based on a chart relationship of oscillators - stochastics - to candle or price action. It's based on the assumption that when oscillators are moving up, so are stochastics. And when prices are moving down, stochastics do too. But it's the magnitude of the price move and its relationship to the stochastic move that determines "divergence"

It's important to understand too that there are two different types of divergence - bullish and bearish. Bearish divergence occurs only from a stochastically overbought chart situation. The meaning here is that the divergence carries a bearish implication for future price action. Conversely, bullish divergence occurs only from a stochastically oversold chart situation. Keep in mind that "overbought" or "oversold" isn't necessarily indicative of divergence.

So come on, Buzz. Spill the beans! What's it look like? To tell the truth, I don't' have a good example of bullish divergence tonight. But maybe I'll think of one before the article is over < big grin >. Isn't it just like Fundamentals guy to hint that he's still building and finds value in a financial ark?

That said, let's take a look at today's Dow Jones Industrial Average (INDEX:INDU) chart. Like I noted above, if there's no bullish divergence example coming immediately to mind, then it follows that this chart is an example of bearish divergence.

Dow Industrial chart - INDU (weekly/daily):

Oh, so that's what it looks like! Wait, one side is different from the other. How can they both be bearish divergence? Ahh, good eye!

Starting on the left side of the chart (weekly), first note that there are two high points in "overbought" in the stochastic part of the chart. Without that, there could be no divergence. Actually, even if only the most recent point were stochastically overbought, it would still count as "overbought" and thus be a divergence candidate. That we have two, one higher than the other, is an added bonus. Anyway, the most recent "overbought" crossover (fast stochastic over slow stochastic) is higher than the last one.

Second, note that for the same period of time, the tops of the candles (not the wicks) show lower price action than the last time. Connecting the stochastic tops and the price candle tops gives us two black lines, which "diverge", hence divergence! Big deal. It's just lines on a chart. Why is that important?

Now for the interpretation part: Think of stochastics as the power behind a price move. The first data point on the candle and the first data point on the stochastic have a relationship. The second data points on each determine the presence or absence of divergence. If both lines were sloped up or both sloped down, there would be no divergence. NEXT! But in this case, we have price sloped down and stochastic sloped up.

It's those second data points that bring this all together in opposing sloped lines. Here's the "big whoop": while the power (stochastic) behind the move up the charts was greater than last time, price did not match it. Price stayed lower despite the power behind it. While the conviction was great, as indicated by the stochastic, the market was not willing to support a higher value. That's bearish. Were the price to have moved higher above it's last top, that would be consistent with a continued upward move. It looks like that upward trend is going to change, give or take a few daily gyrations. (Don't look for Dow 10,000 any time soon.)

Hence, we use the divergence to signal the POSSIBILITY OF A CHANGE IN MARKET DIRECTION. That's one half the explanation. But what about the exact opposite lines on the daily chart? Why is that bearish too?

Refresh your eyesight for just a moment and take another look at the daily side of the chart. In this case, we see a HIGHER price point from the last time and a LOWER stochastic high from the last time. Connecting those points with previous data points, we again see a divergence. While the lines are opposite, it's still a divergence, and still bearish at that.

Here's why. On the daily chart, price has taken off like a shot from a gun. But the power behind it, as shown by a lower stochastic hasn't kept pace with the price before rolling over from overbought. The psychology behind this is that while prices were rising at a frenzied pace, there was little conviction to make it happen. It's like Jim Belushi in the movie, Animal House, running out the door by himself with nobody following after half- heartedly asking the first time, "Who's with me?" His advance was OK, but his stochastic was a little low! He needed to return to rally the troops for a second attempt, with the power of a crazed lunatic yelling, "Who's with me!?"

Related to the market, that second attempt may happen, but it will have to overcome the greater weekly trend.

But the point is that a higher price move with lack of conviction on the stochastic is equally bearish. This also signals a possible change in market direction. Were the lines in either side of the chart moving up or down together, there would be no divergence. Thus the status quo would be intact, and no possible change of market directions could be foretold.

How about an example of that? Your wish is my command (at least for now). Take a look at Dow stalwart, GE.

General Electric chart - GE (weekly/daily):

Note that the slope of the weekly stochastic line and price line are the same - also true for the daily side. There is no divergence here; just an indication of the downward status quo. Thus, we would not expect a reversal in the trend of GE. The weekly trend chart appears to indicate that this uber-company's stock price is headed lower over the next few weeks/months, and not about to change.

Wish we could show a chart undergoing some bullish divergence, but I can't find one! That's OK. We're a patient lot. We'll bring up the subject again when we see it in the charts.

Until then, make a great weekend for yourselves!

Buzz



Options 101 Archives