Divergence is often considered a powerful leading indicator of price. It occurs when there is a discrepancy between the price and a technical indicator. It is a failure of the indicator to confirm the higher high or lower low of the price. This discrepancy or divergence is usually observed on the oscillator type of indicators, such as the RSI, MACD and Stochastic.
The most common type is the Classic or Regular Divergence which is a reversal pattern. It indicates that the underlying momentum in the price may be decreasing and may be approaching a bottom or top. The Regular divergence is a separation between the price and the indicator and warns of a possible short or medium term change of trend. It can be defined as:
The Regular divergence can be further classified into 3 types according to their levels of strength.
Divergence “Class A” is the strongest type of divergence which in turn gives the best trading signals. Class A divergences usually indicate a sharp and significant reversal of the trend.
Divergence “Class B” forms with sufficient momentum but it is advisable seek confirmation with other factors before entering a trade. It is a weaker type of divergence which signals a gradual reversal of trend.
Divergence “Class C” is the weakest type of divergence which normally occurs in choppy market conditions. For purposes of completeness it is mentioned here but trading Class C should be avoided.’