Divergence is one of the most powerful tools (if not the most powerful) for determining and/or predicting immediate future direction, trend strength and end of trend/reversal.
However, most people who try to trade divergences fail. Primarily this is because everyone focuses on the third item above, trend reversal, while completely ignoring the first two. Namely, the fact that *divergence implies the existence of a trend*. Therefore, if you are going to try to trade divergence reversals, you absolutely must have a good method of confirmation to determine if the trend is really over. Otherwise, you are best served trading in the direction of the divergence since trends are more likely to persist.
I noticed several people discussing how to trade divergences recently, and the chart of EURUSD for this morning is a perfect example of different types of market modes (ranging, slow persistent trend, thrusts/stop hunts) and the associated divergences so I decided I would post it as a graphical illustration. Hopefully it will be helpful to some of you in learning how to trade divergences and not get burned =)
If you look at my chart you will notice it does not look like ordinary divergence between peaks that most people use. The calculation is different but they both represent the same thing, the method I use has advantages though in that it allows you to calculate it more precisely and with no lag since you don't have to wait for a peak. Also you can graphically look at the bunching of lines and assess the degree of trend strength and persistence.
Basically, if you want a graphical picture of what divergence is, look at the dotted violet line that oscillates above below the others in the bottom pane. The distance between that line and the ones below it, or more precisely the area between the two curves, is divergence between scales.
You can also think of it as the situation where you have two MA's (like MACD) where the faster MA is above the slower MA and gaining momentum, once it stops gaining momentum they will converge. By definition this MUST happen before trend can reverse, and this is what most people talk about when they talk about trading divergence. Ironically, if you look at that definition again you will see that they are really trading convergence and not divergence, but I digress..
So essentially what my indicator does is look for weakening momentum between different scales, in other words it compares how their slopes are moving compared to one another. I am using wavelet decomposition but you could easily do the same thing using MMA (Wavelets are basically a more generalized and flexible MMA)
IMHO the main key to trading divergence is to develop a clear picture of what it is and why it forms, once you have done that it is pretty easy to develop profitable trading strategies based solely on divergence and convergence.
BTW.. the particle oscillator I posted here is also quite good for measuring divergence =)