Leading technical indicators on a price chart are much like a yellow flag on a racetrack, offering a heads up that a change is maybe just around the bend, and it may be time to snap a new strategy into action.
Some traders find the easiest way to read leading technical indicators—including momentum, money flow, or overbought/oversold oscillators—is to look for chart divergences. That simply means spotting two chart elements that normally correlate but currently are moving apart.
Most so-called "lower" study indicators, such as moving average convergence divergence (MACD), stochastic, and the Relative Strength Index (RSI), usually appear to move in the same direction as the price chart—both moving up or down, and at the same time. An experienced trader might watch for times when the lower study action diverges from price. Depending on the trading strategy, it might be a signal to buy or sell.
Because reading and applying such divergences as a leading technical indicator works the same way regardless of the lower study, the approach described here can be applied to different technical indicators, time frames, and market conditions. This article discusses a few potential advanced trading strategies based on using divergences as a technical indicator.
To get started, let's make an important distinction. There are two types of divergence:
1. Regular divergence appears before confirmation that a trend is about to reverse.
2. Hidden divergence provides confirmation that a trend is intact and likely to continue.
Regular divergence
Regular divergence is more common and easier to recognize. When a security's price makes a new high, add chart trendlines on the new high and use them to check against the lower study. If the indicator is not also making a new high, you have a divergence. Sometimes the indicator will be at a lower high, and other times the indicator will show a similar high. Either way, if the indicator is not making a new high at the same time price is making a new high, there's a bearish divergence.
Source: thinkorswim® platform
For illustrative purposes only. Past performance does not guarantee future results.
If the price is at a new high but the indicator is not, some traders who notice may begin watching for confirmation indicators as potential sell signals. In other words, they may choose to trade in the opposite direction from the trend.
The same analysis can be applied when the price makes a new low. Put the trendlines on the new low and use them to check against the lower study. If the indicator is not also making a new low, you have a divergence. When some traders notice price is at a new low, but the indicator is not, they may begin watching confirmation indicators for a potential buy signal (to trade in the opposite direction from the trend) for this bullish divergence.
Source: thinkorswim platform
For illustrative purposes only. Past performance does not guarantee future results.
Trading a regular divergence
Advanced traders who are familiar with options strategies could use divergences as a potential trade trigger to enter something like a short out-of-the-money vertical spread in anticipation of a trend reversal. This risk-defined strategy benefits from time decay while waiting for confirmation of a buy or sell signal. Keep in mind that a regular divergence indicator for a potential buy or sell signal might appear in the near future, but it's not guaranteed.
Another way to trade a regular divergence is to wait for a confirmation buy or sell signal before entering the trade. That signal might appear as a reversal candle pattern, where the price crosses a support or resistance line. Or it might appear as a trade trigger from a confirming chart study.
Once the price movements show a confirmation buy or sell signal, a directional trade could be entered using a directional options strategy or by buying or selling the underlying security.
Using hidden divergences
Hidden divergences are more difficult to spot because most traders focus on price action first. However, there are times when price is not making a new high or a new low, but the lower study is doing so. This is called a hidden divergence and tends to act as confirmation of the current trend.
When a lower study makes a new high, put the trendlines on the indicator's new high and use them to check the price chart. If the price chart is not also making a new high but may be showing a lower high or a similar high, you might have a bullish hidden divergence.
Source: thinkorswim platform
For illustrative purposes only. Past performance does not guarantee future results.
You can also spot a bearish hidden divergence when your lower study indicator makes a new low, but the price does not make a new low.
Source: thinkorswim platform
For illustrative purposes only. Past performance does not guarantee future results.
Regular or reversal divergences may be easier to spot, but hidden or continuation divergences can precede powerful moves in the direction of the trend.
Bottom line
Just like the alert a yellow flag can give on the racetrack, divergences between lower study chart indicators and price action can be invaluable to traders, potentially giving them a heads up that a trader may want to enter—or exit—a trade in the near future.
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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Schwab does not recommend the use of technical analysis as a sole means of investment research.
Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab.
Spread trading must be done in a margin account.
Please read the Options Disclosure Document titled "Characteristics and Risks of Standardized Options" before considering any option transaction. Supporting documentation for any claims or statistical information is available upon request.
Investing involves risk, including loss of principal.