Do you ever wonder why your trades don’t go as planned? Well, let me tell you. Divergence is what keeps the game of trading exciting and challenging. It’s one of the most practical trading terms that are extremely important to master.
Divergence plays a massive role in the technical analysis regarding indicators and strategies. The thing is, traders often take divergences for granted, which means they need to recognize their actual value.
This article aims to help you understand how divergence works and how to use these signals effectively to improve your trading results.
What is Divergence in Trading?
The term “divergence” refers to the mirror image of a price movement. Technical analysts describe when an indicator (such as the relative strength index (RSI) shifts away from its original path and starts moving in the opposite direction of the price.
Usually, the technical indicator follows the price direction – but in divergence, it slightly moves away or opposite to price.
For instance, If the price moves up or down, making higher highs and higher lows, and the indicator isn’t following the pattern – it’s a divergence.
What are Bullish and Bearish Trends?
When an asset price moves higher in the short term, it is said to be in a “bullish” trend. When an asset price moves lower in the short term, it is said to be in a “bearish” trend. There are also hidden divergences, indicating that a move higher or lower in the market is possible but still needs to be more confident.
Types of Divergence in Trading
There are two main types of divergence: regular – which suggests that a move higher in the asset price is likely, and hidden divergence – which indicates a lower move possibility.
Regular divergence
Regular divergence occurs when a security price makes higher or lower lows while the related indicator makes lower or higher lows. This can signify that the trend is losing momentum and may be about to reverse.
There are two further types of regular divergence:
- Bearish Divergence
- Bullish Divergence
Regular Bearish Divergence
A bearish divergence occurs when a security’s price makes higher highs while a related indicator, such as an oscillator, makes lower highs. This indicates that while the price is rising, demand for the asset is waning, and the selling pressure may increase.
Cheat Sheet for Regular Bearish Divergence:
In this case, the price makes higher highs while the indicator makes lower highs. This indicates a losing momentum in the uptrend – and traders looking for a potential reversal may consider taking a bearish position. This is a golden opportunity for sellers to make good benefits.
Regular Bullish Divergence
Bullish divergence, on the other hand, occurs when the price of a security makes lower lows while a related indicator makes higher lows. It signals a price fall, which means the momentum behind the selling is slowing – and an opportunity exists to buy.
Cheat Sheet for Regular Bullish Divergence
In this case, the price is making lower lows while the indicator is making higher lows. This indicates that the downtrend may be losing momentum, and traders looking for a potential reversal to buy may consider taking a bullish position.
Hidden divergence
In hidden divergence, the indicator makes higher lows or lower highs while the price makes lower lows or higher highs. Hidden Divergence, unlike Regular Divergence, indicates that the trend may continue. It just shifts the direction with no reversal of the trend.
Hidden divergence has two sub-types:
- Bearish hidden divergence
- Bullish hidden divergence
Bearish Hidden Divergence
A hidden bearish divergence occurs when the price of a security makes lower lows while a related indicator, such as an oscillator, makes higher lows. The situation alerts the traders to take selling positions.
There will likely be a bear bias, and a downward trend will continue.
Hidden Bullish Divergence
A hidden bullish divergence occurs when the price of a security makes higher highs while a related indicator makes lower highs.
In this case, the price is making higher highs while the indicator is making lower highs. Here, the trader can expect a bullish or upward trend. This is a perfect time for traders to enter or reenter the market.
How Does RSI Divergence Work in Trading?
The Relative Strength Index (RSI) is a popular indicator that compares the performance of a stock against itself. It is calculated by taking the difference between the down days and up days, then dividing that number by the mean of those numbers. A reading below 70 is considered bullish, while a reading below 30 indicates bearishness.
Conclusion
In a nutshell, divergence is not a ‘get rich quick’ scheme. It is a valuable tool for traders who are comfortable reading forex patterns and can use it to make their trading decisions.
Understanding divergences is essential for beginning traders, even those with more advanced skills.
The key is to keep in mind how they work, how they fit into the bigger trading picture, and what it means when a divergence forms. If you can understand these different uses of divergence and how they are used in practice, you’ll be able to bring new information to the table when you study the markets.
