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All you wanted to know about convergence & divergence in technical analysis

Convergence is a phenomenon when two components move in the same direction. In the world of trading, convergence shows that the direction is supported by secondary factors (technical indicators or price-based studies like moving average, Bollinger Band, Ichimoku). For example, if the index price is rising upward and indicators like moving averages or Relative Strength Index (RSI) move in the same direction, the structure is then said to be in convergence.

Divergence is the exact opposite. Herein, the other component trades in the opposite direction to the main component (the price). Suppose, the price is rising and the indicator, like RSI, is falling; then, such a scenario is defined as a bearish divergence. Some of the most well-known indicators are Moving Average Convergence Divergence (MACD), Relative Strength Index (RSI), Stochastic, Williams %R, Commodity channel index, among others.

In the share market, convergence is also defined in terms of future prices. During the expiry of the contract, the future price is likely to equal the price of spot (cash) price. This phenomenon is known as convergence in price. However, when the future and cash price do not converge, then there arises a likely opportunity for arbitrage.

Impact of convergence and divergence

In technical analysis, divergence is given greater preference as the 'divergence behaviour' may reflect a change in a price trend or sentiment. Such a scenario usually occurs in volatile markets or during a consolidation phase. Normally, convergence is expected to be supportive of the trend and may not impact the overall scenario. However, a divergence may result in a complete shift in the mood of market participants.

Divergences are classified into two components: bullish and bearish signals. A chart depicting a positive divergence shows a bullish underneath sentiment compared to the negative divergence, which denotes a bearish momentum.

In a positive divergence, the technical indicator is highly active, making firm higher highs compared to the price. This shows that the underlying price is about to build firm strength with direction likely to remain in upward bias. The market is expected to rise above the current level and start building a bullish sentiment.

A negative divergence reflects low interest of the indicator in conjunction to the price strength. This inevitably depicts weakening strength and the price is expected to see profit booking ahead.  (ICICI Lombard General Insurance Co Ltd)

Conclusion

Technical experts study divergence more deeply to confirm an outlook and establish a firm strategy. It is relatively comfortable to predict the upside during a bullish market; still, profit booking and reversals are actively studied to maximize the returns and profitability.

On one side, the negative divergence assists in identifying the profit booking or reversal sentiment, whereas the positive divergence helps in determining a bullish trade. The analyst community majorly prefers the Relative Strength Index (RSI) indicator -- known to identify the underneath strength of assets in comparison to the price -- which greatly supports the divergence module.
 
 


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