The Different Kinds of Divergence in Trading
Divergence is synonymous with conflict in trading. When most students refer to, or hear about divergence, it is generally in reference to divergence between price action on the chart and price momentum as measured by a centered oscillator. There are other types of divergence in trading even more important which often go unrecognized. The first divergence is generally between the individuals idea of how a market should work, versus how markets do work. A common example of this would be when price direction contradicts an individual’s economic and or political opinion; or when price appears to be at an extreme price relative to current supply and demand conditions. Then there is the need to understand the potential conflict between expectations over time versus current cash in hand. For example The U.S. Labor dept releases the May unemployment number on the first Friday of June. Technically speaking the price of the Dow Jones Industrial Average in May represented economic conditions which will not be confirmed until June. The same is true of such influential economic measurements as retail sales, or durable goods ordered, or economic sentiment measurements, etc. And time and time again experienced traders will tell you that price reversals in asset class markets occur more often before economic data confirms fundamental conditions than otherwise. This is simply the difference (divergence) between what astute market participants are seeing today, versus what government tabulated data confirms a month later. In other words, price more often leads. And it is at those times when price leads too far, and too fast, when we see pronounced divergence on the longer-term trends between price action on the chart and price momentum as measured by a centered oscillator, which again, is the most common definition of divergence. There is another divergence also which occurs between the different length trends, or cycles, in an individual market. For example the current trend on the 60-minute chart may be up, while the current trend on the daily chart is down—the two trends are divergent. The most important thing about being able to say with confidence that the market is higher on one time frame and lower on another is that it means you have a way to measure market direction, which is the key to trading in my humble opinion. In trading, it always comes back to price; and when a condition or measurment conflicts with price, that’s divergence.
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Jay Norris is the author of the best seller Mastering the Currency Market, McGraw-Hill, 2009, and a Trading Instructor at www.Trading-U.com.
To schedule a complimentary, interactive tutorial with Jay on determining market direction go to One on One Tutorial
DISCLAIMER: Forex (off-exchange foreign currency futures and options or FX) trading involves substantial risk of loss and is not suitable for every investor. Risks include the potential that changing political/economic conditions may substantially affect the price/liquidity of a currency. Investors may lose all or more than their original investments.