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Two Roads Diverged: Trading Divergences

by Alexander Elder (2011)

Quick summary -- an in-depth PhD-level extended summary (10-30 pages) for this book is coming soon.

Two Roads Diverged: Trading Divergences

Author: Alexander Elder | Categories: Technical Analysis, Trading Systems, Indicators

Executive Summary

"Two Roads Diverged: Trading Divergences" by Dr. Alexander Elder is a focused e-book published through Elder.com that concentrates exclusively on one of the most powerful concepts in technical analysis: divergences between price and indicators. Taking its title from Robert Frost's famous poem, the book provides rigorous definitions of bullish and bearish divergences, extensive chart examples across multiple timeframes (from day-trading to investing), reader exercises with answers, and practical trading guidance including entries, stops, and profit targets. Now in its second edition (2014), the book uses MACD-Histogram as its primary indicator but demonstrates that divergence concepts apply to any oscillator. Elder positions this work within his broader "Three M's" framework (Mind, Method, Money), explicitly noting that it covers only the Method component.

Core Thesis & Arguments

Elder's central thesis is that divergences are among the strongest signals in technical analysis, revealing when a trend's internal strength is weakening even as prices continue to make new highs or lows. Key arguments: (1) A divergence occurs when prices make a new extreme (high or low) but the indicator fails to confirm, signaling that the internal momentum driving the trend is fading; (2) Many traders misidentify divergences, applying the term too loosely, and precise definitions are essential for reliable trading; (3) Bullish divergences (found near bottoms) and bearish divergences (found near tops) are mirror images of each other and follow symmetric rules; (4) Divergences in multiple timeframes provide the strongest signals; (5) MACD-Histogram is the preferred indicator for divergence analysis because it combines trend-following and oscillator properties; (6) Divergences identify areas where trends are vulnerable to reversal but do not guarantee reversal - they must be combined with other technical factors and proper risk management.

Chapter-by-Chapter Analysis

Review of Tools

Establishes the foundational concepts needed for divergence analysis: price, moving averages, support and resistance, and MACD-Histogram. Provides standard settings (12-26-9 for MACD) while encouraging personal experimentation.

Bullish Divergence: Definition and Non-Examples

Provides the precise definition of a bullish divergence (prices make a lower low while the indicator makes a higher low) and, critically, shows numerous examples of patterns that are NOT bullish divergences, helping traders avoid false signals.

Bearish Divergence: Definition and Non-Examples

Mirrors the bullish section for bearish divergences (prices make a higher high while the indicator makes a lower high), with equally detailed non-examples.

Reader Exercises

Interactive exercises requiring the reader to identify divergences on unlabeled charts, with detailed answers that explain why each case does or does not qualify.

Entries, Stops, and Profit Targets

Practical trading guidance on how to enter positions based on divergence signals, where to place protective stops, and how to set profit targets using support/resistance and Fibonacci levels.

Advanced Topics

Covers divergences in other indicators (Force Index, Elder-Ray), divergences across multiple timeframes, scanning for divergences, and the MACD Semi-Automatic system for systematic divergence trading.

Key Concepts & Frameworks

  • Bullish Divergence: Prices make a lower low while the indicator makes a higher low, signaling weakening downward momentum
  • Bearish Divergence: Prices make a higher high while the indicator makes a lower high, signaling weakening upward momentum
  • MACD-Histogram: The preferred indicator for divergence analysis, combining trend-following and momentum properties
  • Multiple Timeframe Divergences: The strongest signals occur when divergences appear across multiple timeframes simultaneously
  • Precise Definition vs. Loose Usage: The critical importance of correctly identifying divergences versus pattern-matching errors
  • The Three M's Context: Divergence trading as a Method component that must be combined with Mind (psychology) and Money (risk management)

Practical Trading Applications

  • Scan for divergences between MACD-Histogram and price at potential turning points
  • Enter trades when a divergence is confirmed by a reversal bar or break of a minor trendline
  • Place stops beyond the extreme of the divergence pattern
  • Set profit targets at the nearest support/resistance level or the opposite edge of the recent range
  • Look for divergences on weekly charts first, then use daily charts for timing entries
  • Avoid trading divergences in isolation - combine with support/resistance, moving average, and volume analysis
  • Use divergences primarily as warning signals to exit existing positions, secondarily as reversal entry signals

Critical Assessment

Strengths: The focused scope of the book is its greatest strength. By covering one concept thoroughly, Elder avoids the superficial treatment that multi-topic books often give divergences. The precise definitions, with explicit non-examples, are exceptionally valuable for avoiding common misidentification errors. The reader exercises provide genuine active learning.

Weaknesses: The narrow scope means the book is only useful in conjunction with broader trading education (which Elder acknowledges). The e-book format limits the quality of chart reproduction. Some readers may find the content insufficient to justify a standalone publication, as divergences are typically covered as a chapter within larger books. The lack of statistical evidence for divergence signal reliability is notable.

Key Quotes

  • "To find the truth, look below the surface!"
  • "A trend may appear strong, while below the surface it may be weak and ready to reverse."
  • "Needless to say, I hold no monopoly on wisdom. I've learned my craft from those who went before me."

Conclusion & Recommendation

"Two Roads Diverged" is the most thorough treatment of divergence trading available as a standalone work. Elder's precise definitions and extensive non-examples address the most common source of error in divergence trading - misidentification. The book is recommended for traders at all levels who use oscillators and want to develop a rigorous, systematic approach to divergence analysis. It should be read as a supplement to broader technical analysis education, not as a standalone trading system. Best suited for traders already familiar with Elder's work who want to deepen their understanding of one of his favorite and most frequently cited trading signals.