About divergence
Divergence Problems
“When price movement and oscillator movement move in opposite directions, that is called divergence. Which of the following indicators is more suitable for predicting a trend reversal?”
① RSI
② MACD
③ Stochastic
A fairly popular image of divergence in chart analysis.
However, can we properly explain why a divergence in movement leads to a trend reversal?
This problem can be solved if you understand the differences in the calculation formulas of these three indicators.
Answer
② MACD
Explanation
・Mechanism of divergence
・Differences among oscillator-type indicators
・Notes for use in trading
will be explained.
STOCH (Stochastic) uses %D instead of %K because %K can fluctuate wildly.
“Stochastic is unusable” – is that true?
About the three lines of the Stochastic
Stochastic can be used for trend-following too!
RSI uses the default period of 14 days.
MACD will be discussed later
What exactly is divergence?
・When price is rising, the oscillator’s wave starts to fall
・When price is falling, the oscillator’s wave starts to rise
If you think about RSI, a reading above 50 indicates strong buying pressure, while below 50 indicates strong selling pressure.
Even if price continues to rise, RSI will fall as the upward momentum weakens.
For example, price is rising but RSI drops from 70 to 60.
When an uptrend turns into a downtrend, the upward momentum weakens.
However, note that a weakening momentum does not necessarily mean an immediate reversal to decline.
Momentum may recover and move higher again.
And when using RSI or Stochastic, divergence tends to occur more easily. What does this mean?
RSI and Stochastic values range from 0% to 100%.
Therefore, a small price dip during an uptrend can cause RSI and Stochastic to drop, and vice versa.
Moreover, the numbers compared in RSI and Stochastic have different meanings even if they are the same numeric value.
RSI = Upward range ÷ (Upward range + Downward range)
Stochastic = (Current price − Low) ÷ (High − Low)
Price highs and lows can be compared simply, but oscillators that move within 0–100% have their numerical meaning shift depending on the period measured.
On the other hand, MACD
MACD = Short-term EMA − Long-term EMA
Therefore, regardless of the measurement period, for example if MACD is 100, it means the gap between the short-term EMA and the long-term EMA is 100 units.
MACD: Can it identify tops and bottoms?
When trading, a key caution is that once divergence occurs, you should have a mindset that the trend might change.
It does not always reverse, so for example if price is rising and the oscillator starts to fall, prepare to exit if you own a long position.
Conversely, if you are aiming for a trend reversal, you would sell once the price actually starts to fall.
The basic stance in trading is not to fight the trend, so when using divergence to enter, place stop-losses shallowly.
When aiming for a bottom or top via a trend reversal, large price swings are possible but there is a higher risk of false signals, so caution is required.
Do not blindly trust famous buy/sell signals often found on the internet; understand how those signals are generated before using them!