Tuesday, November 29, 2011

Divergence Trading

Most technical traders know about divergences between indicators and price charts. A bearish divergence comes about when prices make a new high but indicator fails to do so. Bullish divergences require prices to make new lows with the indicator failing to do so.

The novice trader will find divergences on all types of charts. She will observe prices rising but the RSI (for example) remains flat and makes a lower high. The text books will describe this as a bearish divergence, so the trader goes short. Much to her dismay, she finds that prices continue to rise and the indicator continues to make lower highs. So, the trade starts losing money. Most traders have had similar experiences with bullish divergences where prices continue falling while the indicator rises.

The divergence by itself has little technical significance. Yet, the pattern can be helpful in ascertaining the strength of another technical setup. Here is an example. Assume that prices are in a trading range. Price moves up and comes close to the top of the range which should act as resistance. But, it is also possible that prices may breakout from the range and enter a new trend. If the trader sells near resistance and finds that prices are breaking out, she faces an unnecessary loss while finding herself on the wrong side of the market.

Here, a bearish divergence between prices and indicator can suggest that prices have a stronger probability of retreating from resistance. The resistance zone warns that prices may retreat. A similar message comes from bearish divergence. This leads the trader to go short near the resistance area.

Divergences can be useful in cases where loss of momentum can confirm another technical pattern.

1 comment:

AK said...

how would u discribe then the behaviour of money flow indicator? after rising/falling from over sold or over bottom respectively.. the price still reacts in opposite direction for few days,, then catches the right direction ,,till then many traders would have hit the stops... using mif as standlone indicator is not suggested by many technical experts then.... whats its use? simillerly if it has to be used with other indicator.. what is its importance?