I was reading the RSI page on StockCharts.com and came across some interesting conclusions.
I quote: “Positive and negative reversals put price action of the underlying security first and the indicator second, which is the way it should be. Bearish and bullish divergences place the indicator first and price action second.”
That explains why one should not take trades based purely on a divergence between price, and an indicator based on price. When you take a trade based on a bullish / bearish divergence, you are saying that the indicator leads the price action. Now the question is, is that assertion strong enough to stand on its own? is that ‘phenomena’ consistent?
In my own experience, taking trades based solely on a divergence is a hit-and-miss matter. It sometimes works, sometimes fails, and does not seem to contain any edge.
The article notes that In a strong uptrend, bearish divergences are normal. Similarly bullish divergences are normal in a strong downtrend. Hence one should not be too eager to see them as entry signals on their own.
Where I find divergences more of value is when the divergence is between price and a market breadth indicator, such as the cumulative new highs – new lows value. Those divergences I think are more useful as they highlight differences between the outward strength of the market versus the strength beneath the surface.