Recently, many beginners have been asking about technical indicators, and the most easily misunderstood one is the divergence rate. Simply put, the divergence rate is a tool used to measure how far the price is from the moving average. Understanding its meaning can be very helpful for trading.

I have been using the divergence rate myself for several years, and I’ve found that many people use it incorrectly. The core logic of the divergence rate is one sentence: the price will eventually return to the average cost. When the price deviates too far, it signals overbought or oversold conditions.

Calculating it is actually simple: (closing price of the day minus the N-day moving average) divided by the N-day moving average, then multiplied by 100%. A positive result is called positive divergence, indicating a premium; a negative result is negative divergence, indicating a discount. For example, a divergence rate of 3 means the price is 3% above the moving average.

Here’s a clarification: divergence will always exist because prices change rapidly, but moving averages are lagging, so gaps are inevitable. The difference lies in whether this gap is reasonable.

When looking at the divergence rate, the zero line is the most important boundary. Above zero is positive divergence, below zero is negative divergence. There are two situations for positive divergence: moderate positive divergence indicates bulls are in control, while extreme positive divergence signals overbought conditions, so be cautious of a pullback. Similarly, negative divergence: moderate negative divergence shows weakness, while extreme negative divergence indicates oversold, often presenting a buying opportunity.

But what counts as extreme? There’s no standard answer; it depends on market characteristics. For example, the S&P 500 typically ranges from 3% to 5%, while Bitcoin, due to its high volatility, is usually 8% to 10%. Therefore, before using divergence rate, you should backtest to find the reasonable extreme values for each asset.

I recommend confirming with divergence signals. Top divergence occurs when the price hits a new high but the divergence rate doesn’t keep up, indicating weakening momentum; bottom divergence is when the price hits a new low but the divergence rate doesn’t drop further, showing exhaustion of selling pressure. Both signals are quite reliable.

In practical trading, my most common strategy is combining divergence extremes with candlestick reversals. When the divergence rate has already deviated significantly from the extreme, although it’s impossible to precisely predict which candlestick will reverse, this area is usually a low point. Seeing a lower shadow can be a cue to gradually enter positions.

For parameter settings, short-term traders use 5- or 10-day moving averages, swing traders use 20-day, and long-term investors use 60-day. Choose based on your trading style.

Finally, I want to remind you that divergence rate is just an auxiliary tool; the trend is the main focus. In a strong upward trend, prices may stay high for a while and not immediately revert to the mean. Sometimes, they consolidate sideways before continuing higher. So, don’t rely solely on divergence rate for heavy positions; treat it as a warning signal. When the divergence rate of the S&P 500 reaches -5%, consider gradually building a long-term spot position, but absolutely avoid leveraged heavy positions.

In the end, the divergence rate simply tells you how far the price is from the average cost, but the price will ultimately return. Use this characteristic wisely, combined with other indicators and price action, to find good entry points.