Divergence vs Convergence What’s the difference?

Divergence vs Convergence: an overview

There are many trends and tools in the world of economics and finance. Some of them describe opposing forces, such as divergence and convergence. Divergence usually means that two things move apart, while convergence implies that two forces move together. In the world of economics, finance and commerce, 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 evolve. Divergence indicates that two trends are moving away from each other while convergence indicates how they are coming together.

Key points to remember

  • Divergence occurs when the price of an asset and an indicator move away from each other.
  • Convergence occurs when the price of an asset and an indicator come together.
  • The divergence can be positive or negative.
  • Convergence happens because an efficient market will not allow something to trade at two prices at the same time
  • Technical traders are more interested in divergence as a trading signal while lack of convergence is an arbitrage opportunity.

Divergence

When the value of an asset, indicator or index changes, the associated asset, indicator or index moves in the other direction. This is called divergence. The divergence warns that the current price trend may weaken and in some cases may lead to a change in price direction.

The divergence can be positive or negative. For example, a positive divergence occurs when a stock is approaching a bottom but its indicators start to recover. This would be a sign of trend reversal, potentially opening up an entry opportunity for the trader. On the other hand, negative divergence occurs when prices go up while the indicator signals a new low.

When a divergence occurs, it does not mean that the price will reverse or that a reversal will occur soon. In fact, the divergence can last for a long time, so acting alone could result in substantial losses if the price does not respond as expected. Traders generally do not rely exclusively on divergence in their trading activities. This is because it alone does not provide timely trading signals.

Technical analysis focuses on patterns of price movements, trading signals, and various other analytical signals to inform transactions, as opposed to fundamental analysis, which tries to find the intrinsic value of an asset.

Convergence

The term convergence is the opposite of divergence. It is used to describe the phenomenon of the coming together of the futures price and the spot price of the underlying commodity over time. In most cases, traders refer to convergence as a way of describing the price action of a futures contract.

Theoretically, convergence occurs because an efficient market will not allow something to be traded at two prices at the same time. The actual market value of a futures contract is lower than the price of the relevant contract because traders need to consider the time value of the security. As the contract expiration date approaches, the time value premium decreases 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 converge. 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 market inefficiencies.

Key differences

Technical traders are much more concerned with divergence than convergence, largely because convergence is supposed to happen in a normal market. Many technical indicators commonly use divergence as a tool, primarily oscillators. They map the bands (high and low) that occur between two extreme values. They then build trend indicators that circulate within those limits.

Divergence is a phenomenon that is generally interpreted to mean that a trend is weak or potentially unsustainable. Traders who use technical analysis as part of their trading strategies use the 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 an associated asset, indicator or index in technical analysis. For example, there is convergence when the Dow Jones Industrial Average (DJIA) shows gains as its accumulation / distribution line increases.

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