Divergence Is Discrepancy

Category: Finance.

Indicators are a powerful tools and they generally have a very specific function.

Some indicators are very narrow in focus i. e. only relavent in trends or only in compression patterns while other indicators work well in nearly any market patterns. They measure specific aspects of behavior and that behavior is compared to the chart movement. Some of the more common and respected indicators measure over bought/ oversold conditions or trend strength or divergence. There are several indicators that can be used for divergence. I will focus this article on the divergence indicators and how to recognize divergence. They vary in their accuracy as some measure divergence as their primary function and others as a secondary function.

This indicator compares moving averages to each other and gives Bullish and Bearish signals but it s real unique quality is to predict major changes in direction by revealing discrepancies in it s pattern with the chart s pattern before the change. The most recognized divergence indicator is Gerald Appel s Moving Average Convergence Divergence( MACD) . MACD is well respected and the general adage is that MACD will have a significant discrepancy with the stock chart 2- 3 times per year. While the data is the same, the Histogram is not the form that gives the major divergence signals. MACD may be displayed both as a two line indicator and a Histogram. In fact the use of the histogram is somewhat controversial. This is a secondary talent for MACD so for the discussion of divergence, we will focus on the original two line version.

Construed by Thomas Aspray, it attempts to anticipate the cross over of the faster( green) and slower( red) lines which gives a bullish and or bearish signal. In looking for divergence, the two lines are looked upon as one. The classic data points are 12, 27 and For shorter term trading I use a shorter time frame setting of 8, 18 and There is also a Zero/ Center line for reference. The two line chart is formed by entering 3 time frames to the moving average formulas. MACD can predict changes but the time frame can vary dramatically. The prediction is usually right but not necessarily right away.

The predicted change can show up one week or many weeks later. The actual change usually happens at a support or resistance line. Divergence is the measurement of discrepancy. Early divergence should have you looking closely at your chart for your key pivot points. When two things are measured and compared to each other, they are either moving the same way or diverging. That means that the pattern of the indicator may be moving toward the stock( convergence) or away from it( divergence) .

MACD stands for convergence and divergence. This can be confusing and assumes that the stock chart is on top of the indicator chart. Simplify terms( lose the convergence) The normal way to display MACD is to place it in a separate window below the chart window. While you can learn to understand and read MACD this way there is something that can make it easier to learn and interpret. The confusion I mentioned comes from directional terms assigned to MACD. For example, if you placed the indicator window on top of the chart window, convergence and divergence would switch roles. Converging( coming toward) and diverging( moving away) are only relevant because of the position of the two windows.

I prefer to relate divergence to the core issue, bullish or bearish divergence. Divergence is discrepancy. The distinction of convergence and divergence are unnecessary. If you are moving the same direction as the stock you are in sync with it, agreeing with it. It does not matter if you are moving toward or away, you are diverging. If you are not, you are diverging.

That divergence will either have a bullish or bearish warning. Convergence is done away with altogether. I teach my students to use the terms" Bullish and Bearish Divergence" . If MACD is moving down while the stock is moving up, it is Bearish Divergence. Divergence is not too tough to see but it takes time to get comfortable with it. A rising indicator against a falling stock is Bullish Divergence.

Keep in mind that the settings control how far back you can look for relevance. There is no 0 to 100 scale. The 12, 27, 9 settings will let you compare more time than 8, 18, In other words you can not look at a peak in February and compare it s height to a peak 6 months earlier. The Zero/ Center line allows MACD to reset. But you can compare the neighboring few months to any spot you pick as a starting point. You can only use about 2- 3 months of time when using the shorter settings and 3- 4 months with the longer settings.

This is very helpful in learning from history. At any point you can look 2- 3 months either forward or back. You can practice identifying divergence by using the historical data. Divergence in MACD is a real gem. As with any indicator, it is best to have a few opinions and look for multiple confirmations. At 2- 3 times per year it is a great consultant and forecaster of trend change.

Support and resistance lines will generally correlate with the reversal signals predicted by MACD. Interested in learning more? While there is still much more to learn about MACD, Divergence is the first and most valuable characteristic. I invite you to sign up to attend one of my free trading webshops. Ryan Litchfield with BetterTrades

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