A very popular trading technique is divergence trading. A divergence is where a futures contract may have a higher price on a second peak, but the indicator may show a lower price. This described as a Classic Divergence. We will discuss Hidden Divergences in another post.
Often traders take this to mean that the price must retrace or pullback from the high. This is a big mistake, because mathematically, what is happening in the calculation of the indicator is that as each new bar is added to the price, another bar further back must be subtracted. If the new bar is higher and the old bar is lower, you will get a classic divergence in the indicator.
Think of this phenomena of a fat man getting off a teeter totter with multiple small children on the other side. Conversely if more and more small children get on the teeter totter, they can out weigh the fat man.
Another outcome of a Classic Divergence is that the price simply goes flat for a period of time, or you get a second or even third divergence. Be cautious when trading divergences. They can fool you, especially in a long up trend.
I encourage you to be observant of the strength of the divergences that occur when the trend that is changing is rapid or slow. We have an excellent video that shows this effect with a triple classic divergence.
