2022-12-08
Blog Trade

Divergence and convergence

There are countless trends and tools in the world of economics and finance. Some of them describe opposing forces such as divergence and convergence. Divergence generally means that two things move apart, while convergence indicates that two forces move together. In economics, finance, and business, divergence and convergence describe the directional relationship of two trends, prices, or indicators. But as the general definitions show, these two terms refer to how these relationships move. Divergence shows how two trends are moving away from each other, while convergence shows how they will move closer together.

Key points about divergence and convergence in graphs

• Divergence occurs when the price of an asset and an index move away from each other.

• Convergence occurs when the price of an asset and an index move towards each other.

• Divergence can be positive or negative.

• Convergence occurs when the market does not allow an asset to be traded at two prices simultaneously.

• Traders are more interested in divergence as a trading signal while non-convergence is an arbitrage opportunity.

What is divergence?

When the asset’s value or its index moves in the opposite direction to the corresponding signals, this is referred to as divergence. Divergence warns that the current price trend may weaken and, in some cases, may lead to a change in direction. Divergence can be positive or negative. For example, positive divergence occurs when a stock is near the bottom, but its indicators start to rally. This could signify a trend reversal, potentially opening up an opportunity for the trader to enter. On the other hand, negative divergence occurs when prices are moving higher while the index shows a lower rate. When a divergence occurs, it does not mean that the price will reverse or that a reversal will appear soon. Divergence can last long, so if the price does not react as expected, acting on it alone can mean substantial losses. Traders usually do not rely exclusively on divergence in their trading activities because it alone does not provide timely trading signals. Technical analysis focuses on price movement patterns, trading signals, and other analytical signals to inform trades, unlike fundamental analysis, which tries to find the intrinsic value of an asset.

What does divergence tell you?

Divergence in technical analysis may indicate a significant positive or negative price move. Positive divergence occurs when the price of an asset starts to fall while an indicator such as money flow starts to rise. On the other hand, negative divergence is when the new price increases, but the indicator under consideration shows a lower level. Traders use divergence to assess fundamental movement in an asset’s price and the likelihood of a price reversal. For example, investors can plot oscillators, such as the Relative Strength Index (RSI), on a price chart. If the stock is rising and making new highs, ideally, the RSI will also create new highs. If the stock is growing, but the RSI is starting to move lower, this is a warning that the uptrend in price may weaken. This divergence is negative. The trader can decide if they want to exit the position or stop the loss if the price drops. For positive divergence, you have to consider a different situation. Imagine that the stock price is going down while the RSI goes lower with every swing in the stock price. Investors may conclude that the lows in stocks are losing their downward momentum and may soon follow a reversal. Divergence is one of the common uses of many technical indicators, primarily oscillators.

Difference Between Divergence and Confirmation

Divergence happens when the price and the index give different results to the trader. Conversely, confirmation occurs when the indicator and price or multiple indicators show the same effect on the trader.

Limits on the use of divergence

All investors should use a combination of indicators and analysis techniques to confirm a trend reversal before attempting to diverge. However, divergence will not exist for all price reversals; therefore, some other form of risk control or divergence analysis should be used. Also, when a divergence occurs, it does not mean that the price will reverse or that a reversal will appear soon. Divergences can take a long time, so acting on them alone can mean substantial losses if the price does not react as expected.

What is convergence?

The term convergence is the opposite of divergence. This term is used to describe the phenomenon of the futures price and the spot price of the underlying commodity converging over time. In most cases, traders refer to convergence as a way to describe the price action of a futures contract. Theoretically, convergence occurs because an efficient market does not allow an asset to be traded at two prices simultaneously. The actual market value of a futures contract is lower than the strike price because traders must factor in time value. As the contract’s expiration date approaches, the value of time decreases, and the two prices converge. Traders use price differences to make quick profits if prices don’t converge. This continues until prices converge. When prices do not converge, there is an arbitrage opportunity. Arbitrage is when an asset is bought and sold simultaneously in different markets to take advantage of a temporary price difference. This situation takes advantage of market inefficiency.

Understanding convergence

Convergence means that on the last day that a futures contract can be delivered to fulfill the terms of the agreement, the futures’ price and the underlying commodity’s price will be equal. The two prices must converge. If not, there is an opportunity for arbitrage, low risk, and profit. Convergence occurs because the market does not allow the same commodity to be traded simultaneously at two different prices in the same place. So, for example, you rarely see two gas stations on the same block with two very different gas prices at the pump. In the world of futures and commodities, significant differences between the futures contract (near the delivery date) and the actual commodity price are unreasonable. Therefore, if there is a considerable price difference on the delivery date, there will be an arbitrage opportunity and profit potential with zero risk. The idea that the cash price of a commodity should equal the future price on the delivery date is simple. In fact, it means purchasing goods on day X by paying price Y and purchasing a contract that requires the delivery of goods on day X by paying the price of future transactions to happen simultaneously. Buying a futures contract adds an extra step to the process:

• Buying a futures contract

• Delivery

However, the futures contract must trade at or near the price of the actual commodity on the delivery date. If these prices somehow differ on the delivery date, there may be an opportunity for arbitration. That is, by buying the commodity at a lower price and selling the futures contract at a higher price, the net profit can be operationally risked. If the market retreats, the trend will be reversed.

Final word

Traders are much more concerned about divergence than convergence, mostly because convergence is assumed to occur in a regular market. Many technical indicators commonly use divergence as a tool, primarily oscillators. Divergence is a phenomenon usually interpreted to mean that a trend is weak or potentially unstable. Traders who use technical analysis as part of their trading strategies use divergence to analyze the fundamental movement of an asset. The term convergence is the opposite of divergence. This term is used to describe the phenomenon of the futures price and the spot price of the underlying commodity converging over time. In most cases, traders refer to convergence as a way to describe the price action of a futures contract.
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