Investing- Divergence

What is a Divergence?

And How Can I use it to be a Better investor?

October 2, 2009

By Tim McMahon

 Many investment Guru's talk about "Divergence"  but what exactly is a Divergence? How does it help?

What is Fundamental Analysis?

First of all there are two basic types of Stock Market Analysis-  The first type is called "Fundamental Analysis"  and that is where you analyze the "fundamentals" of a company.  Fundamentals are things like earnings, dividends, "book value", etc. 

In a perfect world, that is all you should need to know about a company.  A company with "good fundamentals" should go up and a company with "bad fundamentals"  should go down.  Unfortunately, as companies like Enron and more recently numerous very large banks have shown us often it takes a long time before the true fundamentals are known.  Companies have become experts at classifying debts as assets and all sorts of accounting tricks to hide the true fundamentals.

What is Technical Analysis?

So another method of analysis is in order, it is called "Technical Analysis".  In  Technical Analysis, the company fundamentals don't matter,  what matters is, is the stock going up or down?  Technical analysts use stock charts, patterns and other tools like moving averages, momentum studies, and divergence to determine the strength of uptrends,  and when and where are the best entry and exit points for purchasing a stock for the best odds of making a profitable stock trade.

So what is a Divergence?

 According to the dictionary a divergence is: A moving or spreading apart in different directions from a common point.

And that is a good start in determining what a technical analyst means when he says divergence. 

Basically,  when a stock market technician looks at stock charts he will usually have a price chart on the top and a variety of other charts on the bottom.  One might be the volume chart (showing how many shares have sold in any given period) another might be the MACD (Moving Average Convergence/Divergence). 

This might be a bit confusing because MACD uses divergence in its calculations so that is one "divergence" but when the price "diverges" from the MACD we also get another signal.

In other words, if the price is tending up and the MACD is tending down we get a "divergence".

Our friends at Market Club have put together a video explaining how you can use this divergence between MACD and price in your trading.  And since a picture is worth a thousand words check out this video explanation of  divergence.

 Try MarketClub

Tim McMahon
Editor
Financial Trend Forecaster

Disclaimer: This article is for informational purposes only. Nothing in this article can be construed as individual investment advice. The author may hold shares discussed.  

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