Why Investors Should Be Careful Using Market Divergence Signals

Nearly all technical analysts of stocks and other securities make use of technical indicators to help them make trading and investing decisions.

Technical indicators are created by applying some mathematical calculation or function to the price and volume data of an underlying security. Technical analysts frequently compare the behavior and structure of indicators with the actual price and volume information. Today, I’d like to focus on market divergence signals – what are they, why they don’t always work, and some guidelines for how we can use them as active investors in today’s market.

Divergence Defined

Comparing the two lines gives rise to the concept of “divergence” – a situation where the price of a security is moving in one direction and the indicator in the other.

A significant market divergence signal is regarded as a reliable sign of a pending price trend change. For example, if the price of a security is trending down, while an indicator has started moving higher, technical analysts will conclude that the price of the security is about to reverse and start moving higher as well.

Pitfalls of Divergence

Unfortunately, market divergence indicators happen to be the most overused and poorly understood technical concept, leading many traders to make wrong decisions about the status of the market or the likely direction of a security.

In the last 3-4 years, instances of “negative divergence” have repeatedly been cited as the reason for a pending stock market top by many bearishly inclined analysts.

Conclusion

Here are some high-level guidelines for how traders should use indicators and approach market divergence:

1. Only Price Matters – Nearly all indicators are derived from price and volume information. Your trading or investing decisions should always be driven by what the price is doing, while you can use an indicator to confirm or support the decision. It should never be the other way around.
2. Know Your Indicator – If you are going to commit capital based on any indicator (even in the supporting role) make sure you understand how it is calculated and how it behaves under all market conditions. Most importantly, make sure you understand its limitations and conditions under which its reliability is suspect.
3. No Edge In Divergence –  Price-indicator divergences frequently produce false signals and should always be taken with a big grain of salt, especially in trending markets.