What is Divergence?

By Samantha Baltodano 

TL;DR:

Divergence happens when the current price and the technical indicator of your choosing are heading in opposite directions. It tells you that the current trend is weakening and it may be time to buy or sell a security.

What Is Divergence?

Divergence happens when price moves in the opposite direction of a technical indicator. Examples of technical indicators include the simple moving average, accumulation/distribution, advance/decline, etc. 

It serves as a warning that the current price trend is weakening which could potentially lead to price switching directions.

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To help put this into perspective, let’s run through a use case:

You’re investing in Tesla at $50 per share (sounds like a good deal!)

This is a highly volatile security, so you’ve decided to use an automated investment strategy to reduce your risk and maximize your return (great choice by the way).

You’ve chosen the 10-day simple moving average… but what does this really mean? When will you buy and sell? 

Well, the majority of the time you won’t do anything. If the simple moving average is trending upward and the current price is trending upwards too, Tesla’s got a strong upward trend going. You’ll hold onto your shares.

The same is true when both lines move downward. Tesla hasn’t been doing too hot, so you won’t hold any securities.

The magic happens when these two lines are headed in different directions. 

If the price of Tesla is increasing, but the SMA has started declining to the point that it falls below price then it’s time to jump ship! Chances are that Tesla’s price will start to decrease (but don’t worry, you still sold at a gain!)

If Tesla’s price is decreasing, but the SMA increases to the point where the SMA line is now crossing below the current price then it’s time to buy!

These last two examples are instances of divergence.

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Divergence is your best friend because it tells you exactly when you should buy or sell. Depending on how aggressive your investment strategy is, you may experience divergence often or a handful of times a year.

Additionally, there’s positive divergence and negative divergence. Positive divergence indicates a possible upswing in the price of an asset. Negative divergence indicates a negative downswing in the price of an asset.

Summary

• Divergence is your sign to buy or sell a security.
• Divergence occurs when the price line and the technical indicator line are moving in different directions.
• A positive divergence happens when price is trending down and the technical indicator is trending up. It indicates a possible upswing in price. This is when you buy.
• A negative divergence happens when price trends up and the technical indicator trends down. It indicates a possible downswing in price. This is when you sell.

This is just one of many tools that is used by Archaide. For a full list of strategies and studies available click here.

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