Blog / Divergences on the Stock Market
Divergences on the Stock Market
Divergences might play a very important role in the decision of the professional trader.
For this reason I touch this topic briefly to help and encourage traders to learn more about divergences and their applicability.
Divergences are certain patterns, that show up in the relationship of two charts, usually one price chart and one indicator chart or the price charft of another asset.
Divergences can be identified on different time-frames, be that one minute time frame, 5 minute time frame,
Hourly, daily, weekly or monthly time frame.
Divergences can be considered as pre warning signals and Not as trading signals, and tell us that the current direction of the price, the current trend might be about change.
Usually the higher the time frame and the higher the divergence the greater the probability that a specific divergence will be a trigger for a real trend change.
As the indicator, that is compared to the price charts, the most often used ones are:
- MACD, Breath indicators, Momentum indicators, CCI, RSI, PMO, TICK...
We can categorize the divergences as follows:
- Regular Bullish divergence.
- Regular Bearish divergence.
- Hidden Bullish divergence.
- Hidden Bearish divergence.
Regular divergences are often precursors of pending trend direction changes, while hidden divergences are precursos of trend – continuations.
Probably the most often used one is the Bullish regular divergence, since most market players are trend following Bullish players and they would like to get into the market at lower proices while the trend is in their preferred direction.
You can find description of these divergences for the regular divergences HERE and for the hidden divergences HERE.
Some of the most important market turns in the indices during the past few years preceded by very telling divergences.
Some of theser were (Looking at the S&P5000 daily chart):
- March 9-th 2009 we had a big Bullish regular divergence on the Daily price charts, compared to the MACD indicator (As one example) and it turned out to be a long-term market bottom.
- One of the latest notable regular Bullish divergence occurred July 6-th 2010, which was the precursor of a long rally, that is still in place after almost 8 month.
- One very interesting Hidden Bullish divergence occurred on July 9-th 2009, when the S&P500 index made a higer low, but the MACD indicater made a lower low.
We do not need to constantly be on the lookout for divergences to find proimising one while we are focusing on market activity and potential future direction.
The only time, when we need to check potential divergences are only the following situations:
1 When price formed a Higher high on our time frame (For example on the Daily chart the prices formed a new 10 – 20 day high. The bigger the number of days, the better.)
2 When price formed a lower low on our time – frame. (For example on the Daily chart the prices formed a new 10 – 20 day low.)
3 Price formed a double top. (Looking at Daily time chart, it is more significant, if the tops are more than a few days apart from each other.)
4 Price formed a double bottom.
For the pfredictionwizard users probably the most often used time-frames will be the 5 minute, the hourly and the Daily time – frames, that will need to be screened for divergences, but we can’t expect big reversals looking at the 5 minute divergences.
To make the real trading decisions we need to consider divergences only as warning signal or flashing signals, but not as trading signals alone.
But complemented with some other technical analysis it can be real beneficial. (Confirmed trend change, Volume analysis, other indicator status...)
Very often we get additional supporting information as confirmation looking at market activity. For example before Bullish reversals we might have a so-called exhaustion, when sellers pushed down prices quickly on heavy volume before, but the selling pressure eased by the time the previous minimum retested, presenting a Bullish regular divergence, and the market soon turns upward.
Assuming that our selected time-frame is X (Time unit) and we pinpoint a regular divergence. Question could be how long would it take for the market to work off that divergence. It might happen within 2 – 5 * X or 2 – 5 times the selected time-frame if a regular divergence does not lead to a trend direction change. So for example we detected a regular divergence on the Daily chart of the S&P500 and would like to know, how long could it be played. If we enter the market 3 – 5 days (3 – 5 *X time-frame unit ) later, than it might be late and we might have missed completelly the market movement, triggered by the divergence.
For those, who have good programming skills, the creation of a so-called auto–divergence–finder might not be a difficult task to do.
What is the mass psyhology behind the divergences?
Imagine that after the eruptin of a sudden Bearish event, the market participants panic, and quickly sell off the market on heavy volume, creating a strong Bearish momentum. The market quickly regain ground, and some of the market players, who missed the first opportunity to get long, decide to enter the market the next time, it approaches the previous low levels. The bigger the time – difference from the sudden market low, when the strong selloff first occurred, the more market players might be ready to enter on the long side again. The market might reach a new low on lower volume, when the divergence occurs, and suddenly those Bullish players pull up the market, working off the divergence.
The extent of the move, following the divergence can’t be estimated just based on the particularities of the divergence. It is much better to use other target estimation methods, like Fibonacci levels, support – resistance analysis...
Some of the pro traders having a lot of experience can identify market turning situations without consciously or explicitelly looking at indicators. They have a feel for the market. The application of that hidden, unconscious knowledge happens extremely quickly during trading decisions.
People used to say that price and volume contains all the information. But untrained eye can’t pinpoint areas, on a chart, that is highlighted by the indicators, derived from price. Only one example is the areas of those divergences.