Divergence versus convergence What is the difference?


Divergence Versus Convergence An Overview

Convergence generally means coming together, while divergence generally means parting ways. In the world of finance and commerce, convergence and divergence are terms used to describe the directional relationship of two trends, prices, or indicators.

Convergence

Most traders refer to convergence when they describe the price action of a futures contract. Here, convergence describes the phenomenon of the futures price and the spot price of the underlying commodity approaching over time. Convergence occurs because, theoretically, an efficient market will not allow something to be traded for two prices at the same time. The actual market value of a futures contract is lower than the price of the contract in question because traders must take into account the time value of the security. As the expiration date of the contract approaches, the premium over the time value decreases and the two prices converge. If 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 do not 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. Arbitrage takes advantage of market inefficiencies.

However, in technical analysis, convergence occurs when the price of an asset, indicator, or index moves in the same direction as a related asset, indicator, or index. For example, there is convergence when the Dow Jones Industrial Average gains as its accumulation / distribution line rises.

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Technical analysis focuses on patterns of price movements, trading signals, and various other analytical signals to inform trades, unlike fundamental analysis, which attempts to find the intrinsic value of an asset.

Divergence

Divergence is the opposite of convergence. When the value of an asset, indicator, or index moves, the related asset, indicator, or index moves in the other direction. The divergence warns that the current price trend may be weakening and, in some cases, may lead the price to change direction.

Technical traders are much more concerned with divergence than convergence, largely because convergence is assumed in a normal market. Divergence is interpreted to mean that a trend is weak or potentially unsustainable. Traders use divergence to get a reading of an asset’s underlying momentum.

Divergence can be positive or negative. For example, a positive divergence would occur if a stock approaches a low but its indicators start to rebound. This would be a sign of a trend reversal, which could open an entry opportunity for the trader.

When a divergence occurs, it does not mean that the price will reverse or that there will be a reversal soon. Divergence can last for a long time, so acting only on it could mean substantial losses if the price does not react as expected.

Key takeaways

  • Convergence is when the price of an asset and an indicator move towards each other.
  • The absence of convergence is an opportunity for arbitrage.
  • Divergence is when the price of an asset and an indicator move away from each other.
  • Technical traders are more interested in divergence as a signal to trade.
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Mark Holland

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