One of the very strongest short-term stock trading signals is divergence, and traders are well advised to watch for it.

Divergence occurs when a technical indicator says one thing but the price action disagrees. It’s applicable for almost any indicator, including those based on price, moving averages, momentum, or volume. For example:
• the moving average convergence-divergence (MACD) histogram makes new highs but the price does not rise to reflect this;
• the relative strength index (RSI) exits the overbought range but the price continues to rise; or
• the on-balance volume (OBV) falls but the price doesn’t.

All of these examples demonstrate a disconnect between the price action and the technical indicator. It’s as if (for example) the market considers the bulls in charge when actually the bears are stronger. The bulls may continue to drive the price higher, but the real, underlying strength of the market lies within the bears’ control, although they haven’t yet realised this fact.

In such a case, the technical indicator is almost always correct, not the price action. And therein lies a powerful trading tool, particularly useful for calling short-term entry and exit points. This divergence manifests in two manners:

• Bullish or positive divergence occurs when the price makes a new low which is not confirmed by the indicator. The price can be expected to rise to meet the indicator’s higher level.
• Bearish or negative divergence occurs when the price makes a new high, but the indicator does not follow suit. In this case, the price can be expected to decline to reflect the indicator’s direction.

Below is the current chart of international resources giant BHP Billiton on the New York shares market (BHP:nyse):

At the point on the chart marked by the vertical line, note that the price is making new lows, but the blue histogram of the MACD in the indicator window below the chart is not confirming the move lower. Within days, the bullish divergence played out and the stock price gained.

Below is the same chart for March through May of this year, with the settings changed to enhance subtle differences and the indicator changed from the MACD to the RSI:

Note that the highest indicator reading for the uptrend occurred, not in conjunction with the highest price levels reached, but almost a month earlier. This bearish divergence clearly signalled the lower prices that followed in April and May.

Unfortunately, even with modern programming and technical wizardry, divergence is almost impossible to filter and must be spotted by eye.

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