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Diverge sign in stocks, explained

Chartered Investment Manager

In technical analysis, divergence refers to the disagreement between the price action of a security and a technical indicator (such as the Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD)). Divergence can be an indication of an upcoming change in the price trend, signaling a potential reversal point. Divergence is commonly used by traders and analysts to identify potential entry and exit points in the market.

There are two main types of divergence:

1. Bullish Divergence:

  • Description: Occurs when the price of a security is in a downtrend while the indicator starts to rise.
  • Implication: This type of divergence may suggest underlying strength in the asset’s price, hinting at a possible future upward reversal.

2. Bearish Divergence:

  • Description: Appears when the price is in an uptrend while the indicator begins to decline.
  • Implication: This situation can be a warning sign that the upward price momentum is weakening, signaling a potential upcoming downward reversal.

Examples:

  • RSI Divergence:
    • If the price of an asset is making new highs, but the RSI is not surpassing its previous highs, it is a bearish divergence. Conversely, if the price is making new lows but RSI is not, it’s a bullish divergence.
  • MACD Divergence:
    • Similar to RSI divergence, if the price makes new highs but the MACD does not, it can be interpreted as a sign that the current upward trend may reverse soon.

Note:

Divergence is not a standalone indicator and should be used in conjunction with other technical analysis tools to make more informed trading and investment decisions. It’s important to use divergence as a part of a larger analysis strategy to confirm signals and avoid potential false indicators.

How to find stocks with bullish divergence

Finding stocks with bullish divergence requires a combination of technical analysis tools and a systematic approach to scanning and analyzing securities. Below is a basic guide to identifying stocks exhibiting bullish divergence:

Step 1: Choose a Technical Indicator

  1. Select a Momentum Indicator: Commonly used indicators for detecting divergence are the Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD).

Step 2: Use a Stock Screener

  1. Employ a Stock Screener: Use a stock screening tool that allows you to apply technical criteria to filter stocks. Many online trading platforms offer stock screeners with a range of technical analysis filters.

Step 3: Set Criteria

  1. Input Technical Criteria for Bullish Divergence:
    • Price Action: Look for stocks that have been in a sustained downtrend.
    • Indicator Trend: The selected technical indicator (e.g., RSI or MACD) should be showing an upward trend or movement.

Step 4: Analyze the Results

  1. Analyze the Screened Stocks: Review the charts of the stocks returned by the screener.
    • Observe the price lows and the corresponding points on the indicator.
    • A bullish divergence is present when the price is making new lows, while the indicator is not.

Step 5: Look for Confirmation

  1. Seek Additional Confirmation: To increase the reliability of the bullish divergence signal, look for additional technical confirmations.
    • For example, a break above a significant resistance level, or a bullish candlestick pattern (like a hammer or engulfing pattern) can provide additional confirmation of a potential reversal.

Step 6: Practice Risk Management

  1. Implement Risk Management Strategies: Even with bullish divergence, not all trades will be successful. Use stop losses and set a clear exit strategy to manage the risk.

Tools and Resources:

  • Use advanced charting software that enables you to plot and analyze price and indicator data.
  • Many trading platforms offer built-in tools for identifying divergence and other technical patterns.
  • There are also standalone software packages and online services that specialize in technical analysis and screening for divergence patterns.

Note:

It’s crucial to remember that while bullish divergence can be a strong signal for a potential change in price direction, no indicator is foolproof. It’s essential to conduct further analysis, consider the broader market context, and employ robust risk management strategies to protect your investment.

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