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Divergence is when the price of an asset is moving in the opposite direction of a technical indicator, such as RSI, or is moving contrary to other data. Divergence warns that the current price trend may be weakening, and in some cases may lead to the price changing direction.
There is positive and negative divergences. Positive divergence indicates a move higher in the price of the asset is possible. Negative divergence signals that a move lower in the asset is possible.
- Divergence can occur between the price of an asset and almost any technical or fundamental indicator or data. Though, divergence is typically used by technical traders when the price is moving in the opposite direction of a technical indicator.
- Positive divergence signals price could start moving higher soon. It occurs when the price is moving lower but a technical indicator is moving higher or showing bullish signals.
- Negative divergence points to lower prices in the future. It occurs when the price is moving higher but a technical indicator is moving lower or showing bearish signals.
- Divergence isn't to be relied on exclusively, as it doesn't provide timely trade signals. Divergence can last a long time without a price reversal occurring.
- Divergence is not present for all major price reversals, it is only present on some.
Divergence in technical analysis may signal a major positive or negative price move. A positive divergence occurs when the price of an asset makes a new low while an indicator, such as RSI, starts to climb. Conversely, a negative divergence is when the price makes a new high but the indicator being analyzed makes a lower high.
Traders use divergence to assess the underlying momentum in the price of an asset, and for assessing the likelihood of a price reversal. For example, investors can plot oscillators, like the Relative Strength Index (RSI), on a price chart. If the stock is rising and making new highs, ideally the RSI is reaching new highs as well. If the stock is making new highs, but the RSI starts making lower highs, this warns the price uptrend may be weakening. This is negative divergence. The trader can then determine if they want to exit the position or set a stop loss in case the price starts to decline.
Positive divergence is the opposite situation. Imagine the price of a stock is making new lows while the RSI makes higher lows with each swing in the stock price. Investors may conclude that the lower lows in the stock price are losing their downward momentum and a trend reversal may soon follow.
Divergence is one of the common uses of many technical indicators, primarily the oscillators.
Divergence is when the price and indicator are telling the trader different things. Confirmation is when the indicator and price, or multiple indicators, are telling the trader the same thing. Ideally, traders want confirmation to enter trades and while in trades. If the price is moving up, they want their indicators to signal that the price move is likely to continue.
You can pair divergences with the buy and sell signals of the TradingLab indicator. So for example a "buy" signal from the TradingLab indicator by itself is not a lot of confirmation. If you pair that "buy" signal with a bullish divergence, there is now a much stronger chance the trade will go in your favor.
I would recommend testing divergences out. They are everywhere! You will realize their true power once you start pairing them with the indicator.