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Divergence in Trading

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Divergence is one of the favorite and reliable trading concepts for traders and technical analysts because of the quality of the trading signal it provides. Although technical indicators are lagging in case of divergence, this lagging feature helps the traders to find profitable trading setup and take more reliable entries. Divergence is mostly used by reversal traders but many trend-following traders also use it to exit their position. Divergence can provide a profitable trading signal when combined with appropriate chart patterns and good trading strategies.

When the price of a stock makes a higher high and technical indicators make a lower high, it is called divergence. In short, divergence is formed when price and technical indicator are moving in the opposite direction of each other. In general, when the price of a stock makes a higher high, technical indicators are also made higher high. But whenever price and technical indicators are out of sync, traders should give attention to this chart. In other words, divergence occurs when the technical indicator does not agree with the price movements. Divergence indicates that the strength of the current trend is weakening and the trend can reverse. For this reason, divergence needs the special attention of both reversal and continuation traders.

Types of divergences:

There are two types of divergence.

  1. Regular Divergence
  2. Hidden Divergence

Regular divergence: There are two subcategories of regular divergence described below.

Regular bullish divergence:

Regular bullish divergences are generally found in a downtrend. In a downtrend, the price makes LL (lower lows), LH (lower highs). Whenever price is making lower lows but technical indicators are making higher lows, it’s called regular bullish divergence. It indicates the strength of the running downtrend is weakening and it can reverse. Traders who are waiting to buy this stock at lower prices are now taking advantage of this situation because if the trend reverse they can get the full benefit from the newly starting uptrend.

Regular bullish divergence

Here price was in a downtrend. At a particular point, the price is making lower lows but the indicator is making higher high which is known as regular bullish divergence.

Regular bearish divergence:

This type of divergence is found at the end of an uptrend. In an uptrend, the price makes HH (higher highs), HL (higher lows). In a normal scenario, a technical indicator also does the same. But when the trend is weakening, at some point you will see, price is making higher highs but technical indicators are making lower highs. In short, price and indicators are moving in an opposite direction to each other which clearly indicates that the strength of the trend is weakening and there can be a possible start of a new downtrend. So traders who bought this share before starting to exit their position based on their strategy because if the price starts to fall, their profit will be decreased. So, a regular bearish divergence is used by traders to exit their position.

Regular bearish divergence

In this picture, the price is making a higher high but the MACD indicator is making a lower high which confirms the regular bearish divergence. After this divergence, the price continued in a downtrend.

Hidden Divergence: Hidden divergences aren’t popular like regular divergence but they are also effective because they give a clear indication of trend continuation. They give traders extra confidence for holding their traders for a longer time. There are two types of hidden divergence. The main difference between hidden divergence and regular divergence is the latter gives a reversal signal while the first one gives a trend continuation signal.

Hidden bullish divergence:

When the price is making higher lows but technical indicators are making lower highs, it’s called hidden bullish divergence. This type of divergence mainly occurs in an uptrend. Hidden bullish divergence indicates that price can continue its uptrend. When traders bought a share of a company and find hidden bullish divergence, they get extra confidence for holding their trade or adding more positions.

Hidden bearish divergence:

When the price is making lower highs but technical indicators are making higher highs, it’s known as hidden bearish divergence. Hidden bearish divergence mostly forms in a downtrend and it indicates a continuation of the downtrend. Traders who are waiting to buy shares of a stock and find a hidden bearish divergence forming should avoid buying this share in that time because there is a high possibility of the continuation of the downtrend.

Technical indicators which are used to identify divergence:

In this part of the article, we will talk about the common technical indicators which are used by traders to spot regular and hidden divergence.

Relative Strength Index (RSI):

RSI is one of the commonly used technical indicators which are effective and powerful. It is one of the reliable technical indicators. RSI can provide an accurate divergence signal when used correctly.

Relative Strength Index (RSI)

Look at the chart above, it is a 1H chart of Robi Axiata Ltd. Here the price is making lower lows and the technical indicator should do the same. But in the indicator section, RSI (14) is making a higher low. In short, price and RSI indicators are moving opposite directions to each other. At this point, any trader looking at the chart should look for buying opportunities in this stock according to his trading strategy because the downtrend is going to reverse soon and he can make some quick profit from it. A trader who doesn’t know about divergence will think that the price is in a downtrend and it will continue its trend. But a smart trader who knows about divergence can predict the price movement correctly. So it is important for you as a trader to understand the concepts of divergence and learn to spot them in the live chart.

Commodity channel index (CCI):

CCI is another popular indicator used by traders to identify overbought & oversold zone and divergence.

Commodity channel index (CCI)

This is the 4H chart of Robi Axiata Ltd. Here the price is making lower lows but the indicator is making higher lows indicating the strength of the running downtrend is weakening and there can be a trend reversal or big retracement of the downtrend.

Moving Average Convergence Divergence (MACD):

MACD is also used to identify divergence. Let’s see an example:

Moving Average Convergence Divergence (MACD)

Here the price is making higher highs but MACD is making lower highs. This scenario gives a clear indication of the upcoming trend reversal. See the start of the downtrend after the formation of the divergence. So traders can exit their running long trades in that position. That’s how divergence also helps traders to exit their trade at inappropriate times with the highest amount of profit.

It is not necessary to use every indicator to spot divergence. You can try out different indicators and stick with one which suits your trading strategy. Many traders use two indicators at the same time to spot divergence and you can also do the same.

Divergence with Chart Patterns:

Divergence is not recommended to use as a standalone formula for trading. When divergence is combined with other trading strategies, it can produce better trading signals. Divergence can be combined with various chart patterns. In this section of the article, we will discuss divergence with various chart patterns.

Divergence with the double top pattern:

The double top pattern is a reversal chart pattern that indicates a reversal of an uptrend. When the price is moving in an uptrend and makes two highs at a similar zone, it’s called the double top pattern. Most of the time, you will find divergence in a double top pattern. Divergence in the double top pattern predicts the reversal of the uptrend more accurately because here double top pattern itself indicates uptrend reversal and divergence also indicating the trend reversal. In short, both are confirming the possibility of a trend reversal.

Divergence with the double top pattern

In this picture, the price was in an uptrend making HH (Higher high) & HL (Higher Low). In the marked area, prices made two high at a similar price point which indicates the double top formation. But in the indicator window, the RSI indicator made the second high lower than the first high indicating divergence. Now, look at the next price movement after this formation. The running uptrend reversed to a downtrend.

Double bottom pattern with divergence:

Double bottom is another popular reversal chart pattern that is found at the end of an uptrend. In this pattern, the price makes two low at a very similar price zone. In a downtrend, generally, the price makes multiple LL (lower lows) & LH (lower highs). When the strength of the downtrend is weakening and the price can’t able to make lower lows anymore, many times they make this double bottom pattern. Divergences are also found in most of the double bottom patterns.

Double bottom pattern with divergence

In the chart attached above, the price was in a downtrend. When it made a double bottom pattern at the marked zone, there is also divergence formed in the RSI indicator, both confirming reversal of the downtrend. After this, the price reversed into an uptrend and starts to make multiple HH (higher highs) & HL (higher lows).

Limitation of divergence:

Divergence will not always lead to a trend reversal. Sometime after divergence, price enters in a sideways trend or consolidation. Another important thing to remember, divergence indicates the loss of momentum in trend. It’s not usual to get a complete trend reversal just after a divergence. If you start to take trade just with divergence, it will hurt you. So you need to look for other confluence factors to take entries such as divergence with chart patterns, divergence with reversal candlestick patterns, and divergence in support and resistance zone, etc. Another limitation of divergence is, it’s not obvious to find divergence in every trend reversal. Many times you find divergence in trend reversal but there is no guaranty.

Conclusion:

Divergence is one of the most commonly used trading techniques used by traders. It simply indicates the different movements of price and indicator. Divergence gives a clear signal of loss of momentum. So when divergence is used with a proper trading strategy, it can generate profitable trading signals.

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