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For example the divergence you would see between a MACD, RSI etc... and price action. I am going to start the free education JigSaw offers on order flow and thought i'd ask before i get really deep into it. Take it easy, i'm a newbie
Can you help answer these questions from other members on NexusFi?
The book can never show you divergence because divergence is a result of an indicator which is measuring price action according to a formula. The book or tape measures or records price action like a chart.
I think of divergence as being visible when the market is being controlled by limit order entries as opposed to market order entries. So with market orders when people buy large size aggressively the market moves up as you would expect it to. But if price is falling and all the aggressive selling suddenly gets absorbed by large limit orders on the bid building a long position, and looking at the tape or Cumulative Delta you will see large selling but price will have stopped going down, or slowed down. Ideally for the limit order buyer the sellers see the market isn't going down and stop selling and then start buying to get out of their positions and drive the market up. So here you have divergence because the market doesn't go down with large selling. I use the Jigsaw tools and like them. The free course is well worth going through.
So basically it happens when limit orders are very thick to the point where market orders aren't moving the market as much as they should be, am i right or...? and thanks for your response.
The divergence of price on a chart and an indicator like MACD is not exactly due to order flow -- although in a way, of course, everything is... .
As both @Iamdom and @Dorky point out, what's involved is the relationship of an indicator vs. price action, in terms of time.
A picture always helps.
Here is a price chart with regular MACD. Indicators like MACD, RSI and most others based on price essentially are representing how fast price is moving. MACD does this by comparing a fast and a slower exponential moving average (the lighter line in the chart shows the difference; the orange line is just an EMA of that difference.) So a higher MACD means a higher rate of change, and a lower MACD means a lower rate of change. (You can also just have a simple Rate of Change indicator, which measures the price difference over a fixed interval, and it will work about the same, depending on the interval you choose.)
The chart shows a divergence between price and MACD, with the second MACD high being lower than the first, while price is showing a higher high.
You can see in the chart that the price change in the first upleg went much farther than the second leg in about the same span of time, as marked off by the vertical arrows. This means that the price upmove was slowing between those two points. That's what causes the lower highs in the MACD, and that's what the divergence is.
You can take this as a signal that price is going to reverse, but that will get you into trouble fairly often. It actually only means that price has slowed down. It can then reverse, or return to its old rate of change, or go into a sideways range. Indicator interpretation can be tricky.
Also, you can see visually, from the vertical arrows, that the price advance is slowing down. Does that mean that you could just rely on the chart by itself to tell you what is happening? Well, yes.
Indicators can be helpful, but they don't tell you anything that is not already there.
PS -- of course, another way to look at it is just that the buying leading up to the second point couldn't force price up as far as the earlier buying leading to the first point did, so you could look at this in terms of order flow also, as mentioned by @matthew28. Divergence is looking at how price is changing over time, and it's all buying and selling, basically.
When large order fails to move the market, it's usually referred to as absorption. The first condition you mention could be considered as momentum. And although these two scenarios are in a sense opposite to each other, they can themselves flip into each other. For example , if absorption fails that may lead to momentum in the opposite direction. If there is no follow through to momentum it may go the other way.
Hi,
Rereading your original question I see that @bobwest has done a much better and more comprehensive job of answering than I did (or would have done), with relation to oscillator indicators and price. My answer is more tied in with order flow and what you will pick up in the Jigsaw videos.
Just in the spirit of carrying on the conversation I am not sure I would completely agree that you can't read divergence on the tape or DOM. But maybe this just becomes a question of semantics. For me divergence is simply when something should happen but doesn't, and doesn't have to relate to an indicator. Such as in my earlier point when you see a lot of volume selling aggressively on the tape but price doesn't go down. Another example being a stock that has a good news announcement that comes out but it can't rally and that this is a good indication to go flat, or start looking for a short.
Just my thoughts on a quiet Sunday afternoon.
Yes its all semantics
I am giving my view of things. I try to spot momentum and absorption or rejection. Then i look for their failure. This is how i use the book and tape.