Divergence Analysis: Spotting Trend Reversals in Stock Market
A stock’s (or any other financial trading instruments) trend is said to have reversed when it shifts and moves back in the other direction. Uptrends that turn into downtrends and downtrends that become uptrends are both examples of trend reversals. How would you know if the pattern has changed? The frequency of the different periods would produce a different picture when the price is plotted over a range of time intervals. Even though the price keeps breaching the support levels gradually, there will eventually be a point when it starts to reverse, and at that point, we might think the price has found support.
Many indicators, metrics, and candlestick patterns have been shown to alter a trend’s direction. Several examples include an oscillator’s oversold/overbought reading, a hammer candlestick pattern, a double-bottom chart pattern, etc. When you open demat account on a good platform you can find these indicators. Among them, the divergence is more popular for spotting trends. Simply put, a divergence happens when the stock price and the corresponding indicator begin to diverge from one another, signaling a trend reversal.
What is Divergence?
When an asset’s price moves in the opposite direction from what a technical indicator forecasts, this is known as divergence. Diverging equities signal a price trend that is beginning to wane and then reverse. Technical analysis divergence is a signal of either upward or negative price movement. The price of the asset will decline to a new low when there is a positive divergence, but the indicator that tracks it will display upward trending patterns.
So, a negative divergence happens when the asset’s price increases to a new high while the indicator, such as an oscillator, slows down, and the signaling the beginning of a downturn.
Traders usually employ divergence for two purposes:
- assessing the momentum of the asset price
- calculating the likelihood that a reversal might occur
While the stock price and a technical analysis indicator, such as the Relative Strength Index (RSI), are moving in the same direction, momentum increases. On the other side, negative divergence, which occurs when the stock price increases while the RSI is rising more slowly, is a sign that the uptrend is waning and may even be about to reverse.
Types of Divergence Used For Spotting Trend Reversals
The three different forms of divergences that are used to spot stock market trend reversals are listed below.
Momentum Divergence
The majority of people are only aware of this type of divergence because it is the most prevalent. When the stock price deviates from the readings of any momentum oscillator, such as the RSI, William’s%R, CCI, etc., this is referred to as momentum divergence.
This implies that the momentum of the stock price is deviating from the values of the momentum oscillator, which raises some concerns about the direction of the present trend. Any indicator, such as the ones mentioned above, that reads momentum can identify it.
Volume Divergence
Everyone is aware that volume fosters trends and that a move is more likely to revert when volume is low. Volume divergence aims to pinpoint this in particular. Simply put, if volume is strong during an upswing but lowers during the succeeding upswing that actually surpasses the prior one, investors should exercise caution.
In other words, while the price is breaking records, the corresponding volume data isn’t. The only distinction between the volume and momentum divergence is the indicator used here, which should be used to understand volume data such as the demand index, volume oscillator, etc.
Volatility Divergence
The following are the differences in volatility. This is a little trickier to see than the other two. It is a good contra bet for reversal trades when the volatility of the first peak (or trough) and the subsequent peak (or trough) differ. To identify this change in volatility, we use John Bollinger’s Bollinger Bands®, arguably the most well-known volatility indicator.
The first peak (or trough) only needs to close outside the band for the next peak to open inside the band. Now I’m done. If this is the case, the stock also exhibits a volatility divergence, which raises the prospect of a profitable counter-trend transaction.
Conclusion
Divergence alerts traders to deteriorating price trends and helps them predict the likelihood of a shift in the price trend, allowing them to find better and more reliable trade entry positions. Divergences, besides to reversals, can reveal a trend continuation pattern. As is the case with other forms of technical analysis, investors should use a number of indicators and research methods to support their trading decisions rather than relying exclusively on divergence. Trading on a sophisticated demat & trading app like blinkX will give access to all these tools and indicators. So, you can make correct trades considering the overall picture of trends.
