Trading divergences is the idea that there is an imbalance between price and oscillator, with the assumption that this imbalance will signal a change in price - either a trend continuation or a trend reversal.
Put simply, a divergence is the opposite of a confirmation signal, which is when the indicator and price are moving in the same direction.
What is trading divergences?
Divergence suggests either trend continuation or trend reversal, and is largely used as a leading indicator because it precedes price action. It forms on your chart when price makes a higher high, but the indicator you are using makes a lower high.
A divergence happens because a technical indicator does not agree with the current market price (for example, when the price makes a higher high, but the indicator you are using makes a lower high). This means that a change in direction is likely.
So, traders can potentially use the divergence pattern to enter and exit trades.
Put simply, price must have either formed one of the following in order for a divergence to exist:
- Higher high than the previous high
- Lower low than the previous low
- Double top
- Double bottom
Remember: if you can’t spot any of these on your chart, it isn’t a divergence!
What is a bullish divergence?
A bullish divergence is the pattern that occurs when the price falls to lower lows, while the technical indicator reaches higher lows.
This is seen as a sign that market momentum is strengthening, and that the price could soon start to move upward to catch up with the indicator. After a bullish divergence pattern, it is common to see a rapid price increase.
You can see an example of a regular bullish divergence below - via BabyPips.com.
What is a bearish divergence?
A bearish divergence is the pattern that occurs when the price reaches higher highs, while the technical indicator makes lower highs.
Although there is a bullish attitude on the market, the discrepancy means that the momentum is slowing. Therefore it is likely that there will be a rapid decline in price.
You can see an example of a regular bearish divergence below - via BabyPips.com.
How can you identify a divergence?
You should first see whether the price action has reached a higher high or a lower low. It is helpful to draw lines on your price chart in order to see whether this has happened.
What’s the difference between regular vs hidden divergences?
There are a few key differences between regular and hidden divergences, and they mostly revolve around profit-making.
- Regular divergences can help you collect a big chunk of profit because you’re able to get in right when the trend changes
- Hidden divergences can help you ride a trade longer resulting in bigger-than-expected profits by keeping you on the correct side of a trend
You can see an example of hidden bullish divergence below (compare with the regular bullish divergence above!)
You can see an example of hidden bearish divergence below (compare with the regular bearish divergence above!)
What are some trading divergences tips?
There are a few tips to keep in mind while trading divergences… see some key tips below!
- Use divergence as an indicator, not a signal to enter a trade
- Use it with caution if you’re trading for the first time - and make sure you do your research beforehand
- Wait for the correct signals that a divergence has formed before acting (these are prices formed at either: higher high than the previous high; lower low than the previous low; double top or double bottom - if you can’t spot any of these on your chart, it isn’t a divergence!)