I consider divergences and convergences a very important tool for the technical analyst. Divergence is not an indicator in itself, as it does not have a mathematical formula. However, divergences have the ability to work as a leading indicator of a possible change in direction of price.
Divergence refers to the movement when the price and the indicator have a tendency to move in opposing directions and Convergence refers to the movement of the indicator in line with the price.
There are six different scenarios that occur which are important for the chartist to understand. I have used the Stochastic RSI to illustrate this. However, these can be applied to all oscillating indicators.
- Positive Divergence
- Positive Convergence
- Hidden Positive Divergence
- Negative Divergence
- Negative Convergence
- Hidden Negative Divergence
1. Positive divergence (Figure 1) A positive divergence appears when price moves down and makes a new lower bottom while the Stochastic RSI makes a higher bottom. This confirms a trend reversal from a down to an up move. Most profitable positive divergences show up after a 5 wave down move.
2. Positive convergence (Figure 2) A positive convergent move is when both price and indicator move up and make higher lows or higher highs. A positive convergence move mostly suggests the previous uptrend’s continuation after a correction phase that ends with a higher low.
3. Positive hidden divergence (Figure 3) A positive hidden divergence appears when price moves up and makes a higher low while the Stochastic RSI shows a lower bottom. This pattern mostly indicates that the last price downswing was a correction of the previous up move. Price continues the uptrend after the correction.
4. Negative divergence (Figure 4) A negative divergence appears when price moves up and makes a new higher top while Stochastic RSI makes a lower top. This confirms a trend reversal from an up move to a down move. Most profitable negative divergences show up after a 5 wave up move.
5. Negative convergence (Figure 5) A negative convergence occurs when price and indicator trend down and make lower lows or lower highs. A negative convergent move mostly announces a continuation of the ongoing downtrend after a correction phase ends with a lower high.
6. Negative hidden divergence (Figure 6) A negative hidden divergence appears with price trending down and making lower highs in price while Stochastic RSI makes a higher high. This pattern mostly indicates that the last upswing in price was just a correction for the previous down move and price continues the downtrend after the correction.
Divergences & Convergences provides the probable direction of future price action but do not provide the entry levels. Therefore to make them effective, one must use them in conjunction with other trading techniques like support, resistances, trendlines, candlestick patterns etc.