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Momentum plays a big role in trending markets. It can be pretty obvious that a trend is about to come to an end when the price is beginning to flatten out. However, divergences can signal that a market is undergoing a change even if it’s not completely obvious from a price perspective.
What Is A Divergence?
Divergence is a conflict between an indicator and the price in a market. Momentum indicators like the Relative Strength Index (RSI) and the MACD (Moving Average Convergence Divergence) capture the momentum of price.
It is difficult to read the momentum of price with just naked price charts because the price action doesn’t typically form nice smooth lines like our brains would like.
This is why we have momentum indicators to help us measure the momentum at any given time.
In trending markets, where momentum is a significant factor, we can get trading signals from such divergences. In ranging markets, the moves are not significant enough to take seriously.
In a trending market, when the price shows an uptrend while a momentum indicator shows a downtrend for the same time window, this is a bearish divergence. When price shows a downtrend while a momentum indicator shows an uptrend for the same time window, this is a bullish divergence.
These divergences do not necessarily mean that the trend will reverse, although that does commonly eventually happen. It means that the trend is losing momentum and could possibly terminate. The market could move into a range and trade sideways for a period, only to resume the trend at a later point. Another possibility is that the price will go sideways and then begin moving in the opposite direction of the established trend.
Divergences are great trend termination signals and should be interpreted as a signal to close any open trades you have that take advantage of that trend. You could then continue to monitor the market for signs that the trend will resume or reverse.
How To Use Divergences To Identify Profitable Trading Opportunities
Notice on the following chart of IBM (NYSE:IBM) how the RSI tends to agree with price in terms of uptrends and downtrends.
In contrast, look at this chart of Citrix Systems, Inc. (NASDAQ: CTXS). While the price is moving in an uptrend, the RSI shows the relative strength of the stock in a downtrend. This is a signal that the trend is about to end. As you can see, it was the start of a sideways channel that has persisted for several weeks.
Conclusion
Divergence between momentum and price alerts you to changing conditions in a trending market. These changing conditions give you the opportunity to close a position before the price has made it obvious that the trend is over.
It can also signal to you that the market is about to enter a ranging phase or is about to reverse course. Further confirmation of a continuation or reversal of the trend is needed to confidently trade in either direction.
