Divergence Indicator: Mathematical Tool for Traders
Professional traders use many statistical tools to understand the market trend and the direction it might take. One of the most powerful tools that come to their aid is the divergence indicator. Divergence recognises the technical imbalance between the price of a security and oscillator. Deviation between the trends of these two parameters indicates an impending directional change in the market. Essentially, the market trend of an asset consists of a series of price swings. The slope of the trend line mathematically defines the strength of the swing.
The correlation between indicators and the prices provide valuable insight into the market trends. This involves plotting the price fluctuations and index parameter on the same graph with respect to time. The trader then studies the rise, falls of both the trends, and compares them. Since they are co dependant, a change in one must arguably effect the change in the other. Suppose the prices are rising and make new high but on the contrary the indicator shows little or no rise, and fails to make a high, one can assume that market is about to follow a downtrend in due course of time. Such bullish and bearish divergences can be identified by simply plotting the trends. The real power of this tool, however, lies in quantifying the claims it makes.
Recognising the futures of the price of the asset is probably the simplest and most effective implementation of this tool. However, deeper analysis of the divergence indicator can pin point the precise moment at which the market can be expected to reverse its direction. Determining the strength of divergence and classifying it can help assess the risk factors and aid in deciding whether a particular trade move is effective in terms of returns. This essentially involves understanding whether the change expected would be sharp or slow or whether the market is likely to stagnate. One must however keep in mind that though this statistical analysis is accurate in its prediction, it is unable to include the error signals that can influence the outcome. Market parameters are vulnerable to several other parameters, while this tool assumes these parameters to be unchanged and provides its prediction based on the previous trends. Hence, when all the other conditions that can influence the market sentiment remain unchanged, the divergence indicator can successfully identify the trend the market is likely to follow in near future.
Find more detail about divergence and convergence.