Divergence Analysis - A powerful tool for long-term positioning
Knowledge of the principle of divergence is extremely important for chartists when studying price action and technical indicators. Popular oscillator indicators like the Stochastics indicator, the Moving Average Convergence Divergence (MACD) indicator, and the Relative Strength Index (RSI), to name but a few, are extremely effective tools for trading currencies in ranging markets. Unfortunately their effectiveness is more limited when currencies trend strongly.
During strong trends an oscillator will typically spend prolonged periods in the overbought/oversold zones, breakouts from these regions will often be false as the buying or selling momentum behind the original trend resumes. The concept of momentum behind the predominant market force, which precipitates the trend, is an important one, and it is here where divergence analysis comes to the fore.
Momentum can be thought of as the latent strength of the force behind the underlying trend. Normally a price trend change will be preceded by a decline in the rate of change of prices (loss of momentum). Whilst this is not always the case, (sometimes momentum and price will reverse together, i.e. when prices move sharply off support/resistance) momentum leads price often enough to be effective in warning of impending trend changes in an indicator.
When an indicator (especially those that measure the rate of change of price) movements correspond with those of the price trend (i.e. new high/lows in the indicator match new highs/lows in price) the indicator is said to ‘confirm’ the price trend. If an indicator or oscillator fails to confirm the trend a divergence situation occurs. Divergence is an early warning signal of a potential trend change, knowing that a trend change may be imminent, chartists must watch price data more closely than during scenarios where the indicator confirms new highs and lows.
Divergences between indicators and price may occur more than once before a price reversal, multiple divergences over a lengthy period will typically provide traders with an excellent sign that the momentum behind the price trend has dissipated and an impending price reversal is near.
Traders must confirm any oscillator signal based on momentum analysis (such as divergence) with the price action itself, action should only be taken on a signal when the price series confirms the trend-reversal signal, e.g. – after a price breakout or chart pattern. This rule is an important one, since momentum indicators assume the normal cyclic rhythm seen during rallies and reactions, when trend price movement is in near linear fashion such countercyclical moves are nonexistent, rendering oscillators ineffectual.
As discussed previously there may be multiple divergences between the oscillator and price before a trend reversal. Waiting for a price reversal confirmation before acting on the signal typically avoids the situation where a divergence occurs, a trade is then placed, but the price then continues to a new extreme and a second or third divergence develops.
Let's now look at some examples of divergence between the price series and some oscillators that measure the momentum behind the price trend.
The first chart above shows an AUD/USD daily chart with the RSI and MACD indicators below the main price chart. Three examples of divergence are displayed, with a support line break and trend line breaks acting as price confirmations upon which the trader would have placed their trade after divergence alerts. All three divergences gave the trader a great clue of the looming trend change.
The second chart is a repeat of the first AUD/USD daily chart, but with the Chande Momentum Oscillator (CMO) and Stochastics oscillator placed below. Despite having applied two different oscillators we see the same three divergence patterns between price and the oscillator emerge at exactly the same time. Note, an additional clue, which the price chart gave us to the impending trend reversal, the bullish ‘hammer’ candlestick. I will discuss candlestick reversal patterns in another article but in the meantime take on board that price confirmation can take place via many mechanisms, and if a trader is particularly lucky many may occur simultaneously giving the trade an extremely high probability of success.
The third chart below shows an example of a positive divergence between price and the RSI and MACD oscillators leading to a bullish trend reversal on the NZD/JPY 1 hour chart. Price confirmation was received via two bullish candlesticks, a ‘hammer’ and a bullish ‘belt hold’; whilst not as ideal as a trend-line break this would have been evidence enough for me to initiate the trade.
In my experience I have found that divergence analysis has been especially profitable when examining longer-term price charts such as daily price candlesticks with oscillators. This is most likely because divergence situations unfold in a more predictable manor over longer-term periods as the changing market internals slowly alter the supply/demand balance, precipitating a trend change. This makes intuitive sense when one considers the nature of a marketplace in which shorter-term price movements are more likely to be effected by random market noise or order flow, as opposed to longer-term movements which reflect the structural changes in the supply/demand equation (a boat may effect a wave but not the tide). As we saw in the third chart however, occasionally we can get great examples for more short-term trade situations as well.
We can see that divergence analysis can be very helpful in identifying the beginning stages of a trend reversal, especially over longer-term horizons, and that many different oscillators may issue warning signs at similar times. On a cautionary note traders need to be mindful that oscillators based on price data have outputs that result from the manipulation of the same price data. Watching several different price oscillators over the same period can lull a chartist into a false sense of security, as the oscillators will tend to yield similar results. Waiting for price confirmation before trading should help mitigate the problems resulting from this issue and minimise false trades.