Option Investor
Trader's Corner

Disagreement, Variance, Divergence

HAVING TROUBLE PRINTING?
Printer friendly version

Those three words are synonyms, but only one, divergence, is typically used in technical analysis. Perhaps the concept of divergence would prove easier to understand if one of its synonyms were used. Divergence is any disagreement or variance in price and indicator action. Look for bearish divergences at highs and bullish divergences at lows.

It's as easy as that.

Some examples illustrate the concept.

Note: Charts do not reflect current prices.

Annotated Daily Chart of MER:


Annotated Daily Chart of the OEX:


Divergences can take many forms. Bearish divergences can occur when prices hit a lower high but the oscillator hits a higher or equal one, prices hit an equal high but the oscillator hits a lower or higher one, or prices hit a higher high and the oscillator hits a lower or equal one. The idea is that there's disagreement, variance or divergence in where prices and the oscillator go. Bullish divergences occur when there is any difference in what prices are doing at lows and what the oscillator is doing.

Simple, right? I might think so, but not all experts agree as to what constitutes divergence. Some would limit bearish divergence to a certain combination of price and oscillator highs and bullish divergence to a certain combination of price and oscillator lows. Others believe, as I do, that any disagreement or variance in price and oscillator highs is bearish divergence and any in price and oscillator lows is bullish divergence.

Think of the oscillator action as representing the push behind a move. Price action is the result of that push. If the oscillator indicates that a bigger push resulted in a lower price high, that's bearish divergence. All that pushing couldn't produce a higher price high, so something was wrong. There was some resistance to going higher, with that resistance likely produced by selling into the rise. The same thing would be true if the push were equal but resulted in a lower price high. If prices reached higher, but the oscillator indicated that there was less push behind the move, then something is wrong then, too. The move isn't supported. Similar arguments can be made for any variance in price action and oscillator action at price lows, too, producing bullish divergences.

Even if determining bearish or bullish divergence proves relatively simple, it's not always a wise idea to act immediately when they appear. Bearish divergence worked beautifully to predict the pullback in MER as seen on the chart above, and bullish divergence worked equally well to predict a bounce in the OEX, but divergences don't always work so quickly or beautifully.

Annotated Daily Chart of the NDX:


Although a bearish swing trader could have amply benefited from that first divergence if using a trailing stop that would have protected profits, a position trader thinking that a major rollover was being predicted would have been disappointed. A long trader who had been alerted and who had exited at the first bearish divergence might not have been disappointed.

Divergences warn traders to prepare their trading plans. They do not promise that a move will occur or that the plan will immediately be put into effect.

Notice divergences, devise or revise your trading plan accordingly, but then wait for price action to confirm. For example, it's possible to draw a trendline on that NDX chart supporting prices from early November through February 27, when that trendline was broken. Bullish traders were alerted to potential weakness when the NDX began producing those bearish divergences. Exits for intermediate-term or long-term long plays might have been placed below that trendline. If that trendline hadn't been violated, bullish traders still would have been alerted to keep their exit plans updated.

Divergences are traditionally found when comparing price action with oscillator action, but I also look for another type of divergence: Keltner-style divergence.

Annotated Daily Chart of INTC:


This divergence did result in a downturn in prices. Just as is true with price/oscillator divergences, Keltner-style ones alert traders to refine their trading plans, but those traders still need to wait for price action to confirm.

Divergence isn't difficult to spot, even for the novice technical analyst. I've employed daily charts in this article, but they're just as easy to find on intraday charts, and the same benefits and cautions apply. Whether refining an exit plan or an entry one, use divergences to alert you to be ready, but let price action actually confirm that it's time to put the plan into effect.

 

Trader's Corner Archives