Divergence is often used by traders in their search of the best points to enter trading positions. What is it, what are the types of divergences and how to trade with them? These questions will be answered in today’s article.
Key Takeaways🔑
| →Divergence occurs when there is a difference between the movement of an asset’s price and a specific oscillator. |
| →There are two types of divergences: regular divergence and hidden divergence, each indicating potential trend reversals or continuations. |
| →Additional confirmation tools like trendlines, moving averages, or candlestick patterns can be used to identify optimal entry points when trading divergences. |
Contents
Two types of divergences
We can talk about the divergence when there is a difference in the movement of the price of the underlying asset and the movement of a specific oscillator. You can utilise, for example, the Stochastic Oscillator, the Moving Average Convergence Divergence, the Relative Strength Index or the Commodity Chanel Index.
There are two different types of divergences distinguished. Regular divergence and hidden divergence.
A few words about a regular divergence
The price is moving constantly. It is sometimes creating higher highs or lower lows. When this happens on the price chart, but the indicator line is not showing the same, we can talk about the divergence.
Such a difference in the price action and the movement of the indicator signals that the current trend weakens and we can expect it to reverse.
It is, however, difficult to capture the exact moment when this might happen. Therefore it could be a good idea to use additional tools such as trendlines or candlestick and chart patterns.
The bullish and the bearish divergence
Classic divergence may be either bullish (positive) or bearish (negative). Below you can see a perfect example of a classic bearish divergence on USDJPY.
The bullish divergence appears during the downtrend. The price creates lower lows but the oscillator does not confirm the same action. It forms higher lows or double or triple bottoms instead. The latter is less significant than the higher lows and more often occurs when you are using the Stochastic Oscillator or the RSI.
The bearish or a negative divergence appears while the price is in the uptrend. There are higher highs made by the price action which are not affirmed by the movement of the indicator. The oscillator may create lower highs or double or triple tops.
We can say that a hidden divergence takes place when the oscillating indicator forms lower low or higher high and the price action seems not to do the same.
Such a situation can occur when the price is consolidating or making a correction inside the current trend. It gives information that the trend would most probably continue in the previous direction and as such a hidden divergence is a continuation pattern. So you can use hidden divergences to trade with a trend. It is easy to identify pullbacks with hidden divergences.
The bullish and the bearish divergence
The hidden divergence, similarly to the classic one, has two types. One is the bullish divergence and the other one the bearish.
The bullish divergence appears during the uptrend when the indicator creates lower lows and the price does not make the same. It signals the price is in the consolidation or correction phase and the trend direction will be soon continued.
The bearish divergence can happen during the downtrend. The oscillator shows higher highs and the price action does not. The downtrend is expected to be soon continued.
Trading with the divergences on the Olymp Trade platform
The divergences themselves do not give strong signals to enter a trading position. Nevertheless, they give important information about the future direction of the price. A regular divergence predicts the trend reversal while the hidden divergence the continuation of the trend.
You will need to use an extra technique to confirm the best entry point for your transaction. It can be as simple as the trendline, moving averages crossover or some candlestick pattern. You can also combine the divergences with trading envelopes or the Bollinger Bands.
The bearish divergence becomes more meaningful near the resistance trendline and when a bearish reversal pattern appears during the uptrend.
The bullish divergence is more significant near the support trendline and when a bullish reversal pattern appears during the downtrend.
Pros and Cons of Trading Divergences 📈📉
Consider the advantages and disadvantages of trading divergences:
👍 Pros:
- Provides valuable information about potential trend reversals or continuations
- Can be used as a part of a comprehensive trading strategy
- Offers opportunities for identifying optimal entry points
👎 Cons:
- Requires understanding and skill to accurately identify divergences
- Not a standalone trading signal and should be used in conjunction with other technical analysis tools
- False signals can occur, leading to potential losses
Comparison of Regular Divergence and Hidden Divergence 📊
| Aspect | Regular Divergence | Hidden Divergence |
|---|---|---|
| Definition | Difference in price action and indicator movement, indicating potential trend reversal | Difference in price action and indicator movement, indicating potential trend continuation |
| Occurrence | During uptrends or downtrends | During consolidations or corrections within the current trend |
| Signal Type | Reversal signal | Continuation signal |
Summary
Divergence is a difference in the movement of the price and the oscillating indicator. When one is falling or rising and the other one is not, this is a divergence.
There are two types of divergences, the regular and hidden ones. The first ones inform about a possible change in the trend direction. The hidden divergences give a signal that the trend will most probably undertake its course after a correction or short consolidation.
Both types can be bullish or bearish, depending on whether they occur during the downtrend or the uptrend.
To get your entry point use an additional tool.
Practice catching divergences in a free Olymp Trade demo account. You need to be well prepared and confident if you want to earn profits in the real trading account.
Have you ever traded with divergences? Can you recognise both types on the price chart? Tell us in the comments section which you will find further down the site.
Wish you high earnings!
Q&A on Trading Divergences 🙋♂️
Here are some frequently asked questions about trading divergences:
- Q: What are some common oscillators used to identify divergences?
- A: Popular oscillators include the Stochastic Oscillator, Moving Average Convergence Divergence (MACD), Relative Strength Index (RSI), and Commodity Channel Index (CCI).
- Q: Can divergences be used as standalone trading signals?
- A: Divergences should be used in conjunction with other technical analysis tools and indicators to confirm entry and exit points.
- Q: How can I improve my ability to spot divergences?
- A: Regular practice, studying chart patterns, and gaining experience in different market conditions can help improve your ability to identify divergences accurately.
- Q: Do divergences work in all market conditions?
- A: Divergences can be effective in trending markets but may produce less reliable signals in sideways or range-bound markets.
- Q: Are divergences suitable for short-term or long-term trading?
- A: Divergences can be applied to both short-term and long-term trading strategies, depending on the timeframes and goals of the trader.