thE hAnDbook of tEchnicAL AnALySiSAs we already know, the momentum principle lends itself naturally to stan-
dard divergence, as does the chronological approach to reverse divergence. Now
if we apply the chronological approach to standard divergence, we run into the
following inconsistencies:
- In standard bullish divergence, troughs continue to fall in the main data series,
showing weakness in spite of rising troughs 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. - In standard bearish divergence, peaks continue to rise in the main data series,
showing strength in spite of falling peaks in the supporting data series that
should indicate some underlying weakness in the main data series. This is there-
fore bullish for price and the current larger trend is expected to continue to rise.
As we can clearly observe above, explanation (1) is wholly inconsistent and
contradicts what is expected of standard bullish divergence, and explanation (2)
is similarly inconsistent and contradicts what is expected of standard bearish di-
vergence. Therefore, if we accept the chronological explanation for standard di-
vergence, this will introduce serious ambiguity as it yields a diametrically opposed
forecast to that indicated when applying the momentum principle.
Another approach we can adopt in order to explain reverse divergence would
be to assume that it is representative of some form of contrarian behavior. This
implies that market participants are willing to take a trade contrary to the evi-
dence available with the belief that following the herd is ultimately unprofitable.
But this line of reasoning also eventually leads to some inconsistency, especially if
applied to standard divergence. In fact, such a contrarian would go long when en-
countering standard bearish divergence and short on standard bullish divergences.
In effect, the conclusions reached using a contrarian approach are similar to those
of the chronological approach, whereby traders long standard bearish divergences
and short standard bullish divergences. For all practical purposes, the chronologi-
cal and contrarian approaches are functionally identical.
A better explanation may be had by considering overbought and oversold
levels. Some practitioners refer to overbought and oversold levels in the support-
ing data series as an explanation for subsequent price moves during reverse di-
vergence. For example, it is argued that in the case of bearish reverse divergence
prices are expected to continue to fall as the indicator is already at or approaching
overbought levels. Similarly, with bullish reverse divergence, prices are expected to
continue to rise as the indicator is already at or approaching oversold levels. This
is by far the most logical and reasonable explanation for the continuation of price
in reverse divergent scenarios.
The distinction between a setup being one of reverse divergence or a Bull and
Bear setup is also of great concern since both types of divergences start out as a
continuation of the current larger trend. How does one distinguish between the
two setups? At which point does a reversal of the continuation represent part of a
Bull/Bear setup and how can we distinguish this reversal from the one that would
inevitably occur in a reverse divergent setup? In other words, at which point does