CLASSIC DIVERGENCE

Classic divergence is one of the best-known types of

nonconfirmation. A divergence is a separation between price

and indicator that warns of a possible short- to intermediateterm

change of trend. A bullish divergence arises during a

down move when price makes either a lower low or a double

bottom but the indicator makes a higher low or a double

bottom. A bearish divergence occurs during an up move when

price makes either a higher high or a double top and the

indicator makes a lower high or a double top. Classic divergences

can occur at price tops or bottoms and also at price

corrections.

The chart of PepsiCo [PEP] in Figure 1 shows both a bearish

and a bullish divergence. The stock price rose from April to the

end of May 1995. The oscillator made a top in early to mid-May

at point A. However, when price made a top in late May (point

B), the oscillator made a second top at a lower level. This was

a sign that price momentum was decreasing and warned of a

potential change in trend either from up to down or sideways.

The stock made a corrective decline going into July. At the

price low in mid-July (point D), the oscillator made a second

bottom, but at a higher level. This signaled that downside

momentum had decreased and either a potential rally or sideways

move could occur. The bullish divergence was confirmed

as price resumed its up move.