Divergence is a critical concept in technical analysis of stocks and other financial assets, such as currencies. The "moving average convergence divergence," or MACD, is the indicator used most commonly to track divergence. However, the concept is also useful in other ways. The goal of the technical analyst when using divergence indicators is to spot trend reversals. Early identification of a trend reversal can be highly profitable.
Before you can make sense of divergence, you should grasp the meaning of a trend. A trend is the general direction in which the price of a stock or other asset is moving. A stock, for example, is said to be in an uptrend if the price is advancing. If the price is declining, the stock is said to be in a downtrend. When the price is fairly stagnant, the trend is sideways. The trend refers to the general direction of the prices. Even when a stock is trending up, its price will decline on some days. However, if the price is generally climbing, analysts talk of an uptrend.
If a stock's price is highly volatile, exhibiting wild daily swings, it can be hard to visually interpret the trend merely by looking at a price chart. One tool that analysts use to better identify trends is the moving average. This is calculated by averaging prices over a specific number of days. A 10-day moving average equals the arithmetic average of the stock's average closing price over the previous 10 days. By plotting the daily values of such an average, the analyst obtains a smoother line than the price graph, because up and down spikes in prices tend to cancel each other out over the course of 10 days.
MACD is a technical indicator that quantifies the difference between two moving averages. The idea is fairly simple. When a stock is trending up, the value of the short-term term moving average will be greater than the longer-term moving average. This is because the shorter-term moving average, say the 10-day, will be an average of more recent prices than the 30-day moving average, and during an uptrend recent prices are higher than the past prices. The MACD shows you whether the stock is still advancing at a pace sufficient to retain a gap between the short- and long-term moving averages. When this gap shrinks or disappears, the stock might have lost too much steam and could be in the process of starting an opposite trend.
When working with the MACD, the analyst can select various time spans for the long-term and short-term averages, as long as one average goes significantly further back than the other. In addition, the analyst can simply graph the two moving averages on the same chart and eyeball the gap between them. Another way of checking for divergence is to graph the daily price of the stock and a moving average on the same chart. If the uptrend is to be trusted, there should remain a gap between the stock's daily price and the level of the moving average.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.