Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ====== Divergence ====== Divergence is a fascinating and potent concept in the world of investing. Imagine you're driving a car, and you press the accelerator harder, yet the car starts to slow down. That discrepancy between your action (pressing the pedal) and the outcome (slowing speed) is a divergence. In investing, it occurs when the price of an asset, like a stock, moves in the opposite direction of a technical indicator. While primarily a tool of [[technical analysis]], even the staunchest value investor can use divergence as a powerful signal to peek behind the curtain of market psychology. It’s not a magic bullet, but rather a flashing yellow light on the dashboard, suggesting that the prevailing trend might be losing its conviction. Common indicators used to spot divergence include the [[Relative Strength Index (RSI)]], the [[Moving Average Convergence Divergence (MACD)]], and various [[momentum]] oscillators. ===== The Two Flavors of Divergence ===== Divergence comes in two primary forms, each telling a different story about the battle between buyers and sellers. Think of them as clues about whether the bulls or the bears are getting tired. ==== Bullish Divergence (The 'Good' Kind) ==== A **Bullish Divergence** is a potential sign that a downtrend is running out of steam. It happens when the price of a stock carves out a new low, but your chosen indicator refuses to follow suit, instead charting a //higher// low. * **What it looks like:** The stock price falls from $50 to a new low of $45, but the RSI indicator, for example, moves from a reading of 25 to 30. * **What it means:** Even though the price has dropped lower, the underlying [[price momentum]] is actually strengthening. The sellers are losing their power, and the stage may be set for a price reversal to the upside. It’s a hint that the pessimism might be overdone. ==== Bearish Divergence (The 'Bad' Kind) ==== A **Bearish Divergence** is the opposite; it's a warning that a glorious uptrend might be on its last legs. It occurs when a stock's price pushes to a new high, but the indicator fails to confirm it, instead making a //lower// high. * **What it looks like:** A stock rallies from $100 to a new high of $110, but the MACD indicator posts a lower peak than it did during the $100 rally. * **What it means:** The party might be winding down. Despite the new price high, the buying enthusiasm is waning. This lack of conviction suggests the uptrend is weak and could be vulnerable to a pullback or a full-blown reversal. ===== A Value Investor's Perspective on Divergence ===== Legendary investors like [[Benjamin Graham]] and [[Warren Buffett]] built their fortunes by focusing on a business’s [[intrinsic value]], not by staring at charts. So, is divergence just noise for a value-focused investor? Not at all. When used intelligently, it’s an excellent complementary tool. * **A Signal for Deeper Research:** A value investor doesn't buy or sell based on a squiggly line. However, a divergence can be a powerful catalyst for action. If a stock on your [[watchlist]] shows a strong bullish divergence after a long fall, it might be the perfect time to re-examine its fundamentals. The market's panic might be creating a bargain. Conversely, if a company you own shows a persistent bearish divergence, it’s a great prompt to ask, "Has the market price become detached from reality? Is it time to trim my position?" * **A Barometer for [[Market Sentiment]]:** Divergence provides a window into market psychology. A bearish divergence can signal irrational exuberance, while a bullish divergence can signal excessive pessimism. For a value investor, whose goal is to be "greedy when others are fearful," these clues are invaluable for timing entries and exits more effectively. * **A Warning Sign for [[Value Trap]]s:** Sometimes, a stock looks cheap based on metrics like its [[P/E ratio]], but it just keeps getting cheaper. A persistent bearish divergence on a "cheap" stock can be a red flag. It might suggest that the market sees underlying decay in the business that isn't yet obvious in the annual report. This can help you distinguish a true bargain from a value trap. ===== Practical Pitfalls to Avoid ===== Divergence is a helpful ally, but it can be a treacherous guide if you follow it blindly. Keep these warnings in mind. * **Confirmation is King:** **Never** act on divergence alone. It's a clue, not a conclusion. Look for confirmation from other sources, such as a break of a [[trendline]], a change in [[volume]] patterns, or, most importantly, your own fundamental analysis of the business. * **False Signals in Strong Trends:** In a very strong, sustained trend, divergence signals can appear multiple times while the price continues to march in the same direction. A stock in a roaring bull market can flash bearish divergence for months before it finally corrects. * **Patience is a Virtue:** A divergence tells you that a trend's momentum is //weakening//, not that it will reverse //immediately//. The reversal could take weeks or even months to play out. Acting too soon is a common mistake.