This divergence is called negative divergence. Similarly, when the price makes a new low and the oscillator fails to make a new low, the two are again in divergence. But this divergence is called positive divergence.
When there is divergence, either positive or negative, it is usually a harbinger of change of direction. A negative divergence has bearish implications. Though a new high is made in the price charts, the oscillator doesn't follow and a trend reversal happens. Similarly, a positive divergence has bullish implications. Though the stock makes a new low, the oscillator does not, and the stock rebounds.
At the end of the day, you need to listen to what the price and the oscillators are telling you. And when the two are not in agreement, close your eyes and follow the oscillator. They are usually right.
However, if you want to further improve your chances of taking a right decision, it would pay to look for more confirming signals and treat the divergence signal as only a red flag.
Once this red flag is raised, then look for other factors to confirm an impending reversal. These other factors might include a reversal pattern or a key support or resistance level.
Let us look at a real life example of positive divergence. In this ACC weekly chart below, look at the downward sloping trendline, which has acted as resistance. The stock has been beaten back by the trendline, time and again.
The lower bottom formation in the price charts has been matched by lower bottom formations in the oscillator chart. However, on October 31, 2008, when the stock made a lower low of 369, the oscillator did not make a lower low; it made a higher low.
This was positive divergence. Look at the trendline joining bottoms. While the price trendline is downward sloping because of a lower low in price, the oscillator trendline is upward sloping.
Merely looking at the price pattern, a trader would have continued to be short in the stock, but the oscillator, by its divergence, flashes a red signal. This caution makes your cover the short but you get a buy signal only after the price breaks out of the trendline at 536, around the first week of February 2009.
The returns in this long trade beginning at 536 would have been 67 per cent by exiting at around 900 when the oscillator entered the overbought zone, for the first time since the bullish breakout.
Let's now turn to a real life instance of a negative divergence. In this weekly chart of Glenmark Pharma, look at the higher top formed by the price in June 2008. At the same time, the oscillator failed to make a higher high, setting off the alarm bells for a trader to exercise caution.
At this point, the trader would have either cut his long or waited for the trendline to be violated at 600 in September. At the point, one could have also gone short, resulting in a 53 per cent return when he could have covered the stock lower at around 282, when oscillator entered the oversold zone, for the first time since the bearish breakout.
Most traders are impulsive by nature, basing their decision on price movements alone.
Therefore, they are likely to make more errors. Spotting divergences between the price and the oscillator helps you identify the change of trend early enough. The rest of the crowd will only come to know of the change when that change manifests itself in the price.
The writer is director and head of research, Anagram Capital.