An indicator divergence is simply when price is moving in a direction opposite of an indicator.  I personally like using oscillating momentum indicators for monitoring divergences and have included a stochastic in my methodology for doing so.  In general, oscillating indicators follow price swings up and down which creates their own swings.  The direction of price and the indicator are best seen with lines drawn between two swing highs or two swing lows. 

Divergences are determined by comparing the slope of the line between the price swings with the slope of the line between the indicator swings.  If the slope of the price swings is up and the slope of the indicator swings are down at the same time, then price and the indicator are diverging.  Likewise, if the slope of the price swings is down and the slope of the indicator swings is up, the price and the indicator are diverging.

Why are divergences worth monitoring? 

Because divergences can tell you one of two things:

1.  There is a potential for a trend change.
2.  The current trend is very strong.

Often on major trend changes, the market tips it’s hand by creating a divergence with a momentum indicator.  The market players make one last blow off move up or down creating a significant new high or low.  However, the momentum indicator does not follow which tells up the move was against momentum.  This more often than not is the begining of a trend change and the first wave of a trend change is usually the largest.  For this reason, it’s usually worth risk to try a counter-trend divergence trade if you can keep your risk reasonable.

If a divergence forms but the market continues in it’s trend direction, then you know the trend is very strong.  You’ll want to hop on at the first pull back and ride it as long as you can.  A strong trend can create divergence after divergence after divergence.  Because price is moving in one direction with little pull backs, the oscillating indicators try to swing back and forth.  However since price is not swinging, the oscillator has a hard time swinging which creates the divergences.

Look at the 15-minute EURO futures chart below.  I’ve labeled 4 divergences.

EUR Divergence examples

Divergence A –  This is a clear divergence where price swing lows move down and the stochastic swing lows sloped up.  Price changed direction at this divergence.

Divergence B – Here the price swing highs moved up, but the stochastic swing highs moved down.  The price swing high was a trend turning point.

Divergence C – Here we have a clear divergence very similar to Divergence A.  This divergence signaled a trend up reversal after a very strong move down.

Divergence D – This is actually 3 divergences in a row that failed.  This is an example of divergence confirming a strong trend.  The pull backs were very small in this up move and notice how the stochastic could never swing very low while the trend was strong.  Be very careful not to keep taking counter-trend divergence trades in a strong trending market.  Trying the first divergence is an acceptable risk, but once it fails, don’t fall into the trap of trying to trade each divergence.