In technical analysis, a BULLISH DIVERGENCE occurs when prices trace out a negative pattern, while some important indicator traces out a bullish pattern at the same time. It indicates that bulls are stronger than they appear on the surface and an upside reversal is likely. The key word here is ‘likely.’ It is not ‘certain,’ and you must use proper risk management, in case this signal fails. Divergences do not fail very often, but you can never take them for granted.

Take a look at this daily chart of Google (GOOG). At point A, prices fell to a new multi-months low and so did the indicator, MACD-Histogram. In area B, this indicator rallied above its centerline. I call this ‘breaking the back of the bear.’ Once I see it, I begin watching that stock on the daily basis, waiting for the indicator to decline below zero again and then show an uptick. At point C, MACD, which has by now declined below zero, has ticked up, completing a bullish divergence pattern and giving a powerful buy signal. Let’s go long, with a stop below the latest low.

A BEARISH DIVERGENCE occurs when prices trace out a positive pattern, while an important indicator traces out a bearish pattern at the same time. It indicates that bulls are weaker than they appear and warns you that a downside reversal is likely.

This recent chart of Amazon (AMZN) shows a confirmed uptrend at point A, with prices and MACD rallying in gear with each other. At point B, prices retreat and MACD-Histogram falls below zero, ‘breaking the back of the bull.’ At point C prices rally to a new high, but the indicator rises to a much lower level. When it dicks down (marked by a red arrow, it completes this divergence and flashes a sell signal. Let’s go short, with a stop above the latest high.

Pay attention to the point B on both charts: MACD-Histogram must cross its centerline between the two bottoms or the two tops. If there is no crossover, then there is no divergence!

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