Divergence Analysis
the markets which would eventually precipitate a reversal. This makes sense since
the supporting data series is regarded as representative of the potential underlying
momentum in price. We may refer to this as the momentum principle. However,
this is not the case with the contemporary approach to reverse divergence, where
price is expected to move in the opposite direction to the supporting data series,
that is, against the natural flow of the underlying momentum.
So far, we have managed to reconcile standard divergence with the Bull and
Bear setups by combining the momentum principle and short‐term over‐reaction in
the markets. Unfortunately, if reverse divergence is explained using the momentum
principle, we very rapidly run into difficulty. Numerous attempts have been made
to reconcile and make some sense of reverse divergence, with the most popular in-
troducing a chronological element in order to obviate definitional inconsistencies.
Unfortunately, it does very little to explain why divergence should be read one
way for standard and another for reverse divergence. Briefly, the chronological
approach states that standard divergence should be viewed prospectively whereas
reverse divergence is best viewed retrospectively. In simple terms, it means that
standard divergence is regarded as forward looking and predictive, whereas re-
verse divergence is but a record of what has transpired.
We shall now examine the definitional inconsistencies that arise when using
the chronological approach to explain standard divergence. Let us first apply the
chronological approach to reverse divergence, where it seems to explain why con-
tinuation of the current larger trend occurs:■ (^) In reverse bullish divergence, troughs continue to rise in the main data series,
showing strength in spite of falling troughs in the supporting data series that
should indicate some underlying weakness in the main data series. This is
therefore bullish for price and the current larger trend is expected to continue
to rise.
■ (^) In reverse bearish divergence, peaks continue to fall in the main data series, show-
ing weakness in spite of rising peaks in the supporting data series that should
indicate some underlying strength in the main data series. This is therefore bearish
for price and the current larger trend is expected to continue to decline.
Before applying the chronological approach to explain standard divergence,
let us first apply the momentum principle to standard divergence:
■ (^) In standard bullish divergence, falling troughs in the main data series show
weakness, whereas rising troughs in the supporting data series indicate the
possibility of some underlying strength or gain in momentum in the main
data series. This is potentially bullish for price and the current larger trend is
expected to subsequently reverse to the upside.
■ (^) In standard bearish divergence, rising peaks in the main data series show
strength, whereas falling peaks in the supporting data series indicate the pos-
sibility of some underlying weakness or loss in momentum in the main data
series. This is potentially bearish and the current larger trend is expected to
subsequently reverse to the downside.