Technical Analysis: Divergence Analysis in Trading

In the world of equities trading, employing a balanced strategy is paramount for success. One powerful tool within this strategy is divergence analysis, which can significantly aid in predicting changes in market trends.

Understanding Divergence

Divergence in technical analysis refers to the discrepancy between two distinct data sets. This can manifest between an instrument's price and an oscillator, indicator, sentiment, or another correlated market or instrument price. For many analysts, divergence is seen as a leading indicator, commonly used to pinpoint reversal points or shifts in trend direction within a specified time frame.

It's crucial to integrate divergence analysis within the broader context of price action, current market conditions, and any expected fundamental changes, such as interest rate adjustments. Doing so enhances the accuracy of chart readings and minimises false signals, which are prevalent in trading. While divergence analysis alone is not sufficient, when combined with price action and other technical tools, it significantly improves trading odds.

Types of Divergence

Traders typically scan charts either visually or through automated scripts to identify divergences. There are two main types of divergence: positive and negative.

Positive Divergence: Occurs when the price makes lower lows while an indicator or oscillator forms higher lows. This suggests that the downward momentum is weakening, possibly indicating an upcoming trend reversal.

Negative Divergence: Happens when the price makes higher highs, but an indicator or oscillator registers lower highs. This indicates that the upward momentum is waning, potentially signalling a trend reversal.

In both scenarios, the indicator's movement does not support the price action, hinting at a possible market trend change.

Practical Example: Price Divergence with RSI Oscillator

The Relative Strength Index (RSI) is a commonly used oscillator that measures the change in price percentage. In an uptrend, RSI is expected to make higher highs along with the price action or remain near overbought territory until the trend starts to reverse.

Consider the following chart examples:

Price Action: Shows Divergence Highs (DH)

RSI: Displays lower highs

This scenario represents a negative divergence, warning that the existing uptrend may not be sustained.

Utilising the Percentage Price Oscillator (PPO)

The PPO calculates the difference between two moving averages of price data, presenting it as a percentage. It compares short-term and long-term moving averages to gauge the strength and magnitude of price changes relative to the overall trend.

Traders use PPO in several ways:

Zero Line Crossings: When the PPO line crosses above zero, it suggests the shorter-term moving average is gaining momentum, indicating a potential bullish trend. Conversely, crossing below zero suggests a bearish trend.

Divergence Analysis:

If the PPO line moves in the opposite direction of the price chart, it may indicate a potential reversal or divergence in price momentum, signalling buying or selling opportunities.

Overbought/Oversold Conditions: Extreme PPO values indicate significant deviation from the average, suggesting an imminent reversal or correction.

Incorporating PPO into your trading strategy can help identify potential trend changes, providing an edge in making informed trading decisions.

Conclusion

Divergence analysis is a valuable component of a comprehensive trading strategy. By understanding and correctly applying divergence, traders can enhance their ability to predict market movements and make more informed decisions. Remember, while divergence analysis is powerful, it should always be used in conjunction with other technical tools and within the context of the broader market picture for optimal results.

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Written by Associate Professor Mordechai Katash at UBSS Australia and Strategic Consultant at Mordechai Katash Strategic Consultants

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