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Divergence

Defined as an indicator diverging away from price

Most of the indicators above will display divergence at times; they are MACD, Stochastic, RSI, in fact most oscillating indicators. If price is making lower lows but the indicator is making higher lows, there is divergence. If price is making higher highs but the indicator is making lower highs, there is divergence. This suggests a slowing of momentum and a possible end to the current direction of price.

The two prominent points in a trend where divergence can be seen the most are towards the end of the trend, and towards the end of corrections (pullbacks). For a trigger event, we are looking to use them to alert us to the end of a pullback.

In a bullish uptrend, in order to use divergence to alert us to the end of a pull back we need to see two lows in price, where the second low is lower than the first low. The indicator must also create two lows but where second low is higher than the first low.

In a bearish downtrend, in order to use divergence to alert us to the end of a pull back we need to see two highs in price, where the second high is higher than the first high. The indicator must also create two highs but where second high is lower than the first high.

The following diagram shows us a pullback in a bullish up trend. We see price making a lower low, however the oscillator (in this case stochastic), is showing a higher low. This is divergence and a bullish sign.

 

 

Move on to Step 4 - Module 2 > Trading System Builder Tool Kit: Trading Rules > Trigger: Volume

 

  

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