Reverse Divergences And Momentum

An oscillator’s failure to confirm the higher high or the lower

low of the market is a red flag to most technical traders. Is

there a message when the price diverges from the indicator?

This veteran technician thinks there is.

echnical analysts are constantly

comparing prices and indicators

to see whether they are moving in

gear or if there are discrepancies.

It’s when discrepancies appear

that an alert to a probable change

in trend is given. Most traders are

familiar with the concept of momentum

indicators experiencing

positive and negative divergences

by Martin J. Pring

with price. For instance, as you can see in Figure 1, momentum

makes a series of declining peaks as the price works its

way higher. This indicates that the underlying momentum is

gradually dissipating, signaling that a peak in the price may be

at hand. The opposite set of conditions would be true for a

declining trend. The problem with divergences is that you never

know how many to expect prior to the actual trend reversal.

An unusual but normally reliable discrepancy occurs when

price and momentum switch roles (where the price leads the

momentum indicator), the opposite of the normal situation

just described. That’s why I refer to this phenomenon as a

reverse divergence. Figure 2 shows a reverse divergence at a

market peak. See how the price makes its high at point A, then

makes a lower high at point B, but the oscillator makes a

higher high at B. The fact that the oscillator peaks at B as the

price is declining is what makes this a reverse divergence.

Of course, reverse divergences can also fail, so I like to see

some kind of trend reversal in the price as a confirmation. I’ve

used trendlines in these examples, but a reliable moving

average crossover† works just as well. Figure 3 shows a

reverse divergence in action at a market bottom. Note how the

price makes its final low at point A, but the oscillator bottoms

at point B. This phenomenon appears to work so consistently

because prices are determined by many different cyclic

rhythms, and an individual oscillator only reflects a very

small part of that picture. The type of cycle being reflected

will, of course, depend on the time span of the oscillator, so

the longer the time span, the longer the cycle.

When a price peaks or troughs ahead of the ideal cycle

turning point, it indicates underlying strength or weakness,

depending on whether it’s in a downtrend or uptrend. Perhaps

some other cycle not reflected by the specific momentum

indicator being monitored has now become dominant. At any

rate, when the price peaks or bottoms ahead of the oscillator,

there is a strong possibility that a trend reversal will materialize.