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"The Meaning of Divergences"

I hear many  talking about "divergences" a subject that is often misunderstood.  Anyone who has ever worked on a project involving the development of any particular indicator is aware of the fact that "not all divergences are created equal!" Normally, a divergence between price and an indicator is a warning sign that price may be soon changing direction. Eighty to ninety percent of all divergences between price and an intermediate or long-term indicator "signal" a potential change in the direction of price. That is the reason most people are aware of only this type of signal that is derived thru divergences, also known as "directional signal."

Divergences signify directional signals, only when the "environment" from which the measurements are taken has remained the same thru-out the time period the indicator is designed to cover. The input values must come from the same type of sample. For example, let's say we are employing a 50 day XYZ indicator and over the past 20 days there has been a significant change in the market environment. That means the input values of the indicator come essentially from two different samples: one that covers the first thirty days, and one that covers the last twenty days. Since the market "has changed" the last twenty days, our indicator is no longer comparing apples to apples. Consequently, there is about to be a distortion, which will appear as a "divergence." That "divergence" will remain in place until all the data from the previous market environment are filtered out and are replaced by data that reflect the current environment, so once again we have a homogenous sample.

If a divergence signifies a "directional signal," then on average, price will conform within a time period less than half the time period the indicator is designed to measure. For example, if a 50 day XYZ indicator starts to diverge today, we should expect price to follow within the next 25 days at most. In the meantime, there should not be much price movement. So, if we observe a divergence, but price remains unaffected—and more importantly it continues to defy the indicator past the half point—then we should begin to suspect that our indicator is giving us a much more important signal. It is giving us an "environmental signal." More likely, there has been a significant change in the market's environment, which accounts for the price's ability to maintain course despite the "divergences." Our indicator's inputs are coming from two different samples, that is why we are getting the divergence!

When a variety of intermediate/long term indicators have been diverging with price, for a period longer than half the duration of the period they are measuring, then we need to consider the possibility that the market is undergoing a "cyclical" or "secular" change. If it is, price will continue to move in its own direction and the indicators will again begin to confirm price, as soon as the data from the previous environment are replaced with all current data.

Usually, if a "cyclical" or "secular" change has taken place, in addition to the price being able to stay the course, we will also observe, initially, all the indicators to diverge. But as time goes on, we will see that shorter-term indicators begin to confirm price; while the longer ones continue to diverge. For example, let's say we use the same indicator for two different time frames, a 30 day XYZ indicator, and a 60 day XYZ indicator. Initially both will diverge from price, but if 30 days later, price has held up, the 30 day XYZ indicator begins to confirm price; while the 60 day is still diverging, then more likely the divergence is due to data distortion, because as soon as 30 days worth of latest data were inputted in the 30 day indicator, it started to confirm price.

Many people who are not familiar with mathematical concepts, look at an indicator that is diverging, and because price is not complying, they think that either the indicator has become useless, or the market is "strange" or "weird!" In reality, the indicator, may be giving a much more important signal, one of a "cyclical" or "secular" change in the market, opposed to a directional signal, that indicates simply a change in the direction of price.

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