Foundations: Indicators and Divergence

In a previous Stock Market Made Simple blog, we introduced the concept of using indicators on your stock charts, which you can read here. Today, we will be taking a deeper look at at indicators and how it is presented in Foundations of Stocks and Options Level 2 Class 7. An indicator is a statistical calculation that can be based on a variety of metrics such as the price action of a stock, the volume of shares trading hands on a stock, or even the open interest of a stock. Technical traders will often use these calculated metrics like the exponential moving average (EMA) to help assist them in determining entry and exits on trades.

Again, the main idea is to use an indicator on our stock charts like an oil, gas, or temperature gauge for a car. It should tell us if our car is fine or if something is going wrong by alerting us with a red flag or a blinking dashboard light. Thus, the data an indicator provides is akin to an early warning system. Usually, this ​scenario is what happens, but there are times an indicator will show data different from what the stock charts are doing. Times where the price of the stock is going up, but our indicator is going down. When these moments of opposition happen, they are known as divergence.

Divergence

​Divergence is when the peaks and valleys of the oscillator does not match the current price movement of the stock. When this discrepancy happens, it is a signal that there is an upcoming change in the marketplace. This shift in how the stock is viewed can happen over the course of a day, a week, or even a month or more as a time frame is not necessarily applied. But what it does represents is a shift in the sentiment of the market on how the stock is viewed, and this shift very often leads to a price reversal. Also, it should be noted, the larger the time frame over which the divergence occurs, the larger the size of the reversal, which is likely to follow. There are two types of divergence to keep an eye out for bearish divergence and bullish divergence.

Bearish Divergence

A bearish divergence occurs when the peaks of a stock differ from the peaks of the oscillator.

Bullish Divergence

A bullish divergence occurs when the valleys of the stock differ from the valleys of the oscillator.

In closing, just as a dashboard in your car provides timely information to the driver, indicators are a great way to supplement the data on your stock charts. And as with all indicators, the signals they provide are only indicators of possible market action. It is good to use them, and when the signals discussed in this blog occur, you should be particularly aware of a possible upcoming price reversal. However, using them for detailed trade entries and exits should be avoided.

As always, if you wish to learn more, please consider signing up for our Foundations of Stocks and Options class, which you can do here. Thank you for reading, and we hope to see you next week as we dive into the Foundations of Stocks and Options Level 2 Class 8!