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Divergence vs. Convergence: An Overview
There are numerous trends and tools in the world of economics and finance. Some of them describe opposing forces, such as divergence and convergence. Divergence generally means two things are moving apart while convergence implies that two forces are moving together. In the world of economics, finance, and trading, divergence and convergence are terms used to describe the directional relationship of two trends, prices, or indicators. But as the general definitions imply, these two terms refer to how these relationships move. Divergence indicates that two trends move further away from each other while convergence indicates how they move closer together.
Key Takeaways
- Divergence occurs when the price of an asset and an indicator move away from each other.
- Convergence happens when the price of an asset and an indicator move toward each other.
- Divergence can be either positive or negative.
- Convergence occurs because an efficient market won't allow something to trade for two prices at the same time
- Technical traders are more interested in divergence as a signal to trade while the absence of convergence is an opportunity for arbitrage.
Divergence
When the value of an asset, indicator, or index moves, the related asset, indicator, or index moves in the other direction. This is what is referred to as divergence. Divergence warns that the current price trend may be weakening, and in some cases may lead to the price changing direction.
Divergence can be either positive or negative. For example, positive divergence occurs when a stock is nearing a low but its indicators start to rally. This would be a sign of trend reversal, potentially opening up an entry opportunity for the trader. On the other hand, negative divergence happens when prices go higher while the indicator signals a new low.
When divergence does occur, it does not mean the price will reverse or that a reversal will occur soon. In fact, divergence can last a long time, so acting on it alone could be mean substantial losses if the price does not react as expected. Traders generally don't exclusively rely on divergence in their trading activities. That's because it doesn't provide timely trade signals on its own.
Technical analysis focuses on patterns of price movements, trading signals, and various other analytical signals to inform trades, as opposed to fundamental analysis, which tries to find an asset's intrinsic value.
Convergence
The term convergence is the opposite of divergence. It is used to describe the phenomenon of the futures price and the cash price of the underlying commodity moving closer together over time. In most cases, traders refer to convergence as a way to describe the price action of a futures contract.
Theoretically, convergence happens because an efficient market won't allow something to trade for two prices at the same time. The actual market value of a futures contract is lower than the contract price at issue because traders have to factor in the time value of the security. As the expiration date on the contract approaches, the premium on the time value shrinks, and the two prices converge.
If the prices did not converge, traders would take advantage of the price difference to make a quick profit. This would continue until prices converged. When prices don't converge, there is an opportunity for arbitrage. Arbitrage is when an asset is bought and sold at the same time, in different markets, to take advantage of a temporary price difference. This situation takes advantage of inefficiencies in the market.
Key Differences
Technical traders are much more concerned with divergence than convergence, largely because convergence is assumed to occur in a normal market. Many technical indicators commonly use divergence as tools, primarily oscillators. They map out bands (both high and low ones) that occur between two extreme values. They then build trend indicators that flow within those boundaries.
Divergence is a phenomenon that is commonly interpreted to mean that a trend is weak or potentially unsustainable. Traders who employ technical analysis as part of their trading strategies use divergence to read the underlying momentum of an asset.
Convergence occurs when the price of an asset, indicator, or index moves in the same direction as a related asset, indicator, or index in technical analysis. For example, there is convergence when the Dow Jones Industrial Average (DJIA) shows gains at the same time that its accumulation/distribution line is increasing.