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Demystifying Convergence and Divergence

We have previously discussed how to navigate the indicator maze and select the optimal choice of indicators from among the hundreds available with most charting packages.  The next question faced by traders - especially those new to the market - is how to use indicators effectively.  There are primarily two ways. One, is to generate overbought and oversold readings, with the premise that a market is likely to undergo a correction in the opposite or divergent direction when these extreme conditions develop.  The other is to use them to assess whether or not they are convergent with the price action.

At TWP, we use the MACD and the RSI.  These indicators integrate well and are key components of the two trading strategies we teach, The Trend Flow Strategy and The Momentum Breakout Strategy. We take a pragmatic and at times alternative approach to traditional technical analysis.  In line with this, we do not use the overbought and oversold readings generated, but rather - as mentioned above - look for convergence and/or divergence.  This approach is underpinned by our philosophy that price action lies at the heart of technical analysis - when indicators and price action converge, they generate a strong signal about the robustness of a trend and its direction.  Furthermore, in our opinion, convergence and divergence signals tend to have a higher predictive value, and allow indicators to be used in a more leading, rather than lagging fashion.

New traders can find the art of reading convergence and/or divergence challenging.  However, when simplified and broken down into logical steps, the task of assessing both directions becomes easier to follow.

In an uptrend, we look for convergence by comparing the highs made by the price action to the highs made by an indicator (as shown in the chart above).  If the indicator makes new highs as the price action is making new highs, we say that it is convergent with the price action.

But if the indicator drifts lower while the price action is making new highs, then it is divergent (as shown in the chart below).  

Convergence in the context of an uptrend is called bullish convergence, while divergence in an uptrend is called bearish divergence.  In a downtrend, we compare the lows made by price to the lows made by the indicator. If the lows made by the indicator are in sync with the price action, we call this bearish convergence. Conversely, if the indicator moves in a direction opposite to the price action we call this bullish divergence.  Ideally, only the latest and prior swing highs or swing lows should be considered.  Earlier swing highs and lows cease to be relevant, with their divergence or convergence having played out.

The important thing to remember about reading convergence is that in an uptrend we compare highs with highs, and in a downtrend, we compare lows with lows. The names or labels are unimportant - so long as price and indicator move in the same direction we have convergence, if not, we have divergence. Finally, it is worth noting that indicator convergence and divergence have limited utility on their own. They only serve to strengthen our reading of market direction when used in conjunction with analysis of other technical factors.

By Nilay Guha – Trade with Precision

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