Divergence Trading: The Ultimate Guide

In the market, divergences occur when the price doesn't move in accordance with an indicator. A divergence is created whenever the price makes a new high or low, but the indicator doesn't. The signal can be used to hunt for reversals or close current positions.

Intro

Divergence has always been attractive to financial markets. According to the Merriam-Webster dictionary, deviation is the act of moving away from the course or standard.

A trading situation occurs when a stock's price moves against an indicator. While indicators lag behind price action, so do the indicators. This lagging feature will actually help us find better and more reliable entry points into trades when there are divergences. Trend-following traders can also use divergences to time their exits. Both reversal and trend-following traders can use divergences.

Divergence trading generally refers to a disagreement between a price and an oscillating indicator, such as MACD or RSI. It is not a strong enough indicator to place a trade, but it gives some insight into the market's condition. Another exciting concept in technical analysis is the divergence between the indicators and the prices. Therefore, technical analysts and traders should pay closer attention to this concept. 

This article will cover what divergences are, how to recognize them, types of divergences, and how to use them effectively.

Divergence is a technical indicator indicating a major increase or decrease in price. An indicator, such as money flow, starts climbing while the price of an asset makes a new low. A negative divergence occurs when a price makes a new high, but the analyzed indicator makes a lower high.

Traders use divergence to determine the underlying strength of an asset's price, as well as the likelihood that there will be a price reversal. For example, investors can plot oscillators on a price chart like the Relative Strength Index (RSI). If the stock rises and make a new highs, ideally, the RSI is also reaching new highs. If When the RSI starts making lower highs, this indicates that the price uptrend is weakening. This is what is known as negative divergence. Once the trader has determined whether or not to exit the position, they can set a stop loss if the price drops.

The opposite of trading divergence is positive divergence. As the stock price makes new lows, the RSI is making higher lows with every stock price swing. Lower lows in the stock price may indicate a trend reversal is imminent as they lose downward momentum. The oscillators, in particular, are often used to measure divergence as one of their common uses.

What is divergence in trading?

In the financial market, divergence can be viewed in various ways. An indicator you are using makes a lower high than the price on your chart, thus forming a divergence. If your indicator and price action are out of sync, this means "something" is happening on your charts that requires your attention. It is not as evident just by looking at your price chart. Trading divergence occurs when your indicator does not match the price action.

Technical indicators, for example, can define a trend reversal period as a period during which an asset's price is moving in one direction while indicators are guiding it in the opposite direction. It occurs only when the price of an asset moves contrary to a technical indicator, such as an oscillator, or when it moves contrary to other data. Divergence indicates a weakening price trend, and in some cases, could lead to a change in price direction. Technically, it can be defined as a period when an asset's price moves in one direction, but its indicators point opposite.

Divergence trading is both positive and negative. The positive divergence suggests the asset could move higher at a price. When there is a negative divergence, a move lower is likely. Divergences indicate the market is moving in a direction. Divergences indicate either continuation or reversal, depending on their type. No adding the location filter to your trading system can almost always improve your signals and trades no matter what type you use. You would look for divergences and trend shifts rather than taking trades based on divergence signals alone to enter a business.

Due to the fact that divergence does not provide timely trade signals, it should not be relied upon exclusively. There is a long period of divergence without a reversal in price. There isn't divergence in every major price reversal, only in some.

Types of Divergences 

An oscillator relative to price measures the momentum and price movement and divergences form when there is a mismatch between the two. Divergences tend to occur near levels of support and resistance quite often.

Divergences can therefore not only help time your entry into a trend but also help you to figure out where support and resistance levels are.

There are two main categories of divergences.

• Regular divergences 

• Hidden divergences 

Regular divergences 

There are two subcategories of regular divergences: regular bullish divergences and regular bearish divergences. These divergences can be useful for identifying price reversals.

• When the actual prices for the stocks are lower than the higher lows indicated by the indicator, it is called a regular bullish divergence.

• When the actual price shows higher highs than indicated by the indicator, it is a regular bearish divergence.

Hidden divergences 

In the same way as regular divergences, hidden divergences have two types. Bullish hidden divergences and bearish hidden divergences. Hidden divergence is the opposite of a regular divergence, indicating that a down retracement is over and the trend will continue. 

• This is called a hidden bullish divergence when the actual stock price shows higher lows than the indicator's lower lows. There is a huge possibility of a trend reversal or at least a retracement of the downtrend if bullish divergences develop.

• The stock price shows lower highs than the indicator's higher highs when there is a hidden bearish divergence. A bearish divergence indicates a potential decline in the stock price.

How to Spot Divergence in Trading?

Traders use divergences to determine whether a trend is weakening, causing a trend reversal or continuation. 

Mark successive tops and bottoms with lines

As you can see, you only have four options: a higher low, a lower high, or a flat low. Using that high or low as a guideline, draw a line backward. It must correspond to successive major highs and lows.

Connect only the TOPS and BOTTOMS

After establishing two swing highs, you need to connect the TOPS. After establishing two swing lows, you need to connect the BOTTOMS.

Make sure you pay attention to the price

Comparing your chosen technical indicator with the price action is the next step. No matter which indicator you use, remember you are comparing their TOPS and BOTTOMS. MACD and Stochastic are an indicator with multiple lines all stacked on top of each other.

Consistent Highs and Lows for Your Swing

In addition to connecting two highs on price, it is necessary to connect the two highs on the indicator. Lows must also be connected. In order to draw a line connecting two lows on the indicator, you must also draw a line connecting two lows on the price. 

Maintain Vertical Alignment of Prices and Indicators

If you identify highs or lows on the indicator, they must correspond to the highs or lows of the price. Ensure vertical alignment between the PRICE swing highs and lows and the INDICATOR swing highs and lows.

Keep an eye on the slopes

Indicator divergence exists only when the line connecting the tops and bottoms of the indicator differs from the line connecting the tops and bottoms of the line connecting the price.

Catch the next ship if the ship has sailed

If As soon as divergence is spotted, but the price has already reversed and moved in one direction for some time, it needs to be considered played out. The time has passed. In the meantime, you'll have to wait for another swing low/high to form and then restart your trading divergence search.

Taking a step back

The more the time frame, the more accurate the divergence signals are. Less false signals are produced. As a result, you will have fewer trades, but your profit potential can be very high if you structure your trade well. Divergences are more frequent on shorter time frames, but they are less reliable.

Trades should be entered after understanding some key factors.

1. It is necessary to use a chart with at least two variables to detect divergence. The Relative Strength Index (RSI) indicator is one of the tools that can be used for this purpose. 

2. If the RSI indicates a trend reversal, such as when a downtrend becomes an uptrend, pay attention.

3. Look for a divergence such as a market high followed by a slightly higher market high on the chart.

4. Multiple factors can cause divergences in price. Traders must be aware of these factors.

If the oscillator should also be making higher highs as the price makes higher highs. The oscillator should also be making lower lows if the price is making lower lows. The price and the oscillator must be diverging if they are NOT. Divergence trading can spot weakening trends or reverses in momentum, which is why it is so useful. There are times when it can even serve as a signal that a trend is about to continue!

After some practice and the passage of time, you will be able to spot divergences in real-time and capitalize on them.

How to Trade Divergences?

For new traders, trading divergences is actually quite difficult. Divergences do not provide an initial signal of when to buy or sell because they do not provide an initial signal of when to buy or sell. There are still some ways to trade these divergences using indicator-specific strategies.

MACD Divergences as a Trading Tool

MACD is a famous indicator used to demonstrate divergences in the market. In the MACD, the shorter moving average period is subtracted from, the longer one.

Moving averages of 26 days and 12 days have been most popular. 9-day moving averages have usually been used as signal lines. As a result, the MACD turns the normal moving average into an oscillator. When two lines cross, there is a trading signal in MACD. In most cases, it is a bullish signal if it happens below the neutral line. It is usually a bearish signal if it happens above the neutral line as well.

An asset's price forms a lower low while the MACD forms a higher low when there is a bullish divergence in MACD. The lower low indicates a continuation of the current trend, but the higher low indicates a loss of strength.

In the same way, a bearish divergence is formed when the price of an asset offers a high while the MACD makes a lower high. Alphabet stock has a bearish divergence in the chart below.

Trade Divergencies with the RSI

The Relative Strength Indicator (RSI) is another tool for trading divergences. Among the most popular indicators in the world today, this one is number one. Overbought and oversold levels are commonly identified with this indicator.

By calculating the average gain and loss over a given period, the indicator is determined by adding gains and losses over a specific period. 

Generally, a buy signal appears when the index falls below 30, which is the oversold level, whereas a sell signal appears when the RSI exceeds 70. So when the RSI is rising, and the price is falling, there is a divergence.

Below is the chart of the GOOG chart showing the divergence trading that formed.

Using a stochastic oscillator to identify divergences

The stochastic oscillator helps to identify divergences. The stochastic oscillator can also identify overbought and oversold conditions as a two-line indicator. A bullish trend is evident when the two lines cross below the lower line and continue rising. In the opposite direction, a bearish trend is evident.

A bullish divergence can be seen on the GOOG chart below. The two stochastic oscillator lines are rising, even though the share price is falling.

In addition to divergence trading, there are other popular strategies. In addition to momentum, you can also use the relative vigor index and the divergence indicator.

Limitations of Using Divergence

As Divergence alone may not be a sign of a trend reversal, as is the case with everytechnical analysis. Investors can use combination of indicators and analysis techniques to confirm trend reversals. In addition to divergence, some other form of risk control or analysis must also be used in conjunction with price reversals.

In addition, when divergence occurs, it doesn't necessarily mean a price reversal will occur soon. In the event the price doesn't react as expected, acting on divergences alone could mean substantial losses.

It is not recommended to use divergence trading as a standalone indicator when determining a trend reversal. For reaffirming reversal patterns, other analysis techniques should be utilized in addition to the indicators. Although diverging patterns may begin to appear, they do not guarantee a price reversal anytime soon.

As Divergence occurs over a prolonged period of time, using it as a standalone tool to predict an exit or entry position can lead to many lost opportunities and unrealized or realized losses if the asset price does not move as expected.

Divergence can give false signals when used as part of a trading system. It occurs when the indicator changes direction but the price trend does not reverse as predicted. When the indicator gets extremely overbought or oversold, this will quite often happen. While the trend's momentum weakens, it continues in the same direction.

Final Thoughts

Professional traders use divergences as one of their proprietary trading strategies for making money, especially if they are already using indicators like RSI or MACD to find overbought and oversold levels, but it should not be relied on alone and requires practice.

This approach is indeed widely used. For you to trade it well, all you have to do is identify the indicators you will use, understand them, and practice using a demo account.

The concept of technical analysis is one of the most important and most commonly used. There is no synchronization between the indicator and the price movement. Stock price divergences can be interpreted in many ways, including as indicators of positive or negative stock price movements. A number of indicators, such as relative strength indexes (RSIs), are useful in identifying divergence. However, to be successful, you must be patient and only enter the trade after confirmation. However, with the proper application at the right place, divergence trading can lead to good profits.