V.12:1 (45-48): Price/Oscillator Divergences by W. Lawson McWhorter

Price/Oscillator Divergences By W. Lawson McWhorter

Have Dow theory divergences always fascinated you? Well, you're in luck. Here's a primer on observing divergence between indicators and prices to generate trading signals.

Divergence, or the nonconfirmation of price movement by a related market, security or technical indicator, has long been a useful part of the technician's repertoire. The importance of divergence was first recognized by Charles Dow and his successor, William Hamilton, in what has become known as the Dow theory. One of the central premises of this method is that any move in the Dow Jones Industrial Average (DJIA) must be confirmed by the Dow Jones Transportation Average (DJIA). If the industrials are making new highs while the transports are unable to break old ones, the strength of the primary trend is called into question.

Figure 1 demonstrates a typical Dow theory divergence; in it, as the industrials set new records, the transports failed to better highs set in April. While the Dow theory is certainly not without its detractors, the concept of divergence forms the foundation of many different technical studies and has become a pillar of technical analysis.

While not referred to as such, divergence plays a vital role in the proper analysis of classic chart patterns. Chart analysis generally calls for volume to confirm price movement; the absence of proper volume is essentially a form of divergence. As Edwards and Magee state in Technical Analysis of Stock Trends:

[Volume] is always to be watched as a vital part of the total picture. The chart of trading activity makes a pattern just as does the chart of price ranges. The two go together and each must conform to the requirements of the case.