Convergent trading strategies look for prices to revert back to a mean. This can mean that two assets that are extended away from their historical correlation will eventually regain their past relationship. Convergent can also describe a trading style of selling short an overbought asset or buying an oversold asset believing that the price is too high or too low and will revert back to an average price during the time of the trade.
When a stock, commodity, or currency drops below the historical price mean, it can be considered undervalued. When an asset trends far above the historical mean, it can be considered overvalued. The belief with a convergent trade is that the current price will return to the mean from its extended price level. A convergent trader will make money by betting against extreme price moves continuing in the current direction.
Convergent trading signals can be created using Bollinger Bands or Keltner Channels by measuring standard deviations from the mean of the 20 day moving average. Over three standard deviations from the 20 day moving average is considered extreme. The Relative Strength Index (RSI) is another measure of price moving too far and too fast in one direction. Over 70 RSI is considered extremely overbought in most timeframes and the 30 RSI is considered oversold.
Convergent trading systems on average have high win rates. This type of strategy bets on the end of a current trend and a return to normalcy. A good convergent trader will stop out for a loss if the entry is too early and the trend continues far enough to show the trade is wrong. A bad convergent trader will hold the losing trade as it goes against them in disbelief creating a big loss.
Divergent trading strategies are the opposite. A divergent strategy bets on price moving in an extreme trend farther than is expected by several deviations above the historical mean. A divergent trading system usually has a lower win rate as it gives a lot of false breakout signals and will experience more extreme whip saws back to the mean before getting aboard a strong trend. The wins with a divergent can be huge when they happen.
Having both convergent and divergent trading signals inside of one system can many tims help profitabilty in multiple market environments and smooth returns out over the long term.
