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Divergence is when an indicator
trends in one direction and price trends in another direction. Specifically, an indicator
will make lower highs while price
makes higher peaks, or the indicator will make a higher low even as price tumbles to new
lows. Divergence is a reliable trading
signal, but it’s not timely, meaning that price usually follows the direction of the
indicator, but it make take months
before it does.
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Bearish Divergence
Bearish divergence (see above chart) occurs
when price makes a higher high but the indicator forms lower highs. The two data
streams diverge in direction. Price will
eventually, usually, follow the indicator lower.
Identification Guidelines
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Characteristic |
Discussion |
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Price trend |
Upward forming higher peaks. |
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Indicator trend |
Lower peaks. |
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One month |
I found that the best divergence
signals in the RSI and CCI indicators are when the peaks are spaced less than 2
months apart – 1 month apart is best (daily charts only). |
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Trends |
Draw a trendline along the
price peaks and it should slope upward. A trendline drawn along the indicator peaks
should trend downward. Don’t
draw trendlines along the valleys when looking for bearish divergence.
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Trading Tips
If the price trend is up, then look for divergence among the peaks, not the valleys. When you spot divergence,
recognize that the price trend may change. This doesn’t mean an immediate
sale, but you should be ready to flee.
Bullish Divergence
Bullish divergence (see above chart) occurs
when price makes a lower low but the indicator forms higher lows. The two data
streams diverge in direction. Price will eventually,
usually, follow the indicator higher.
Identification Guidelines
|
Characteristic |
Discussion |
|
Price trend |
Downward forming lower valleys. |
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Indicator trend |
Higher valleys. |
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One month |
I found that the best divergence
signals in the RSI and CCI indicators are when the peaks are spaced less than 2
months apart – 1 month apart is best (daily charts only). |
|
Trends |
Draw a trendline along the
price valleys and the trendline should slope downward. A trendline drawn along the
indicator valleys must slope upward. Don’t
draw trendlines along the peaks looking for bullish divergence. |
Trading Tips
If the price trend is down, then look for
divergence among the valleys, not the peaks. When you spot divergence,
recognize that the price trend may change. This doesn’t mean an immediate buy,
but consider taking a position soon,
especially if you receive other confirming signals.
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