"Divergence is probably one of the most sought after method of trading. It is a phenomenon and a widely used method by traders to spot potential retracements or reversals in the trends. Divergence is most adept when used in the context of the trend and support and resistance based methods. The concept of divergences is very old and was initially mentioned by Charles Dow of the famous Dow Theory. But the interesting part is that divergences can be spotted in any type of market, including the forex markets. Now a days, divergences are traded based on analyzing price and the oscillator. Trading with divergence requires a lot of practice and also the ability to familiarize oneself to the patterns that emerge. In this article, we give you the lowdown on what are divergences and how they are formed. You will also be able to identify the different types of divergences that are formed in the markets."
Divergence, as the name suggests indicates when two comparable elements do not confirm to the same direction. In simple terms, if you price of a security moving in one direction, compared to the indicator moving in the opposite direction, a divergence is set to have formed.
Divergence is called a leading indicator as it signals a possible retracement or even a reversal of trend direction.
The concept of divergence was made popular by Charles Dow in his Dow Theory. Charles Dow used the Dow Jones Industrials Average and the Dow Jones Transportation Index to look for divergences. According to Dow, both the industrials and transportation index must confirm to each other.
Thus, if the industrials average posted new highs, the same should be seen in the Transportation index as well, and vice versa. When there was a divergence, such as the industrials rising to new highs but the transportation index not rising to new highs, there was an anomaly in the markets.
This potentially indicated that a correction was on the horizon.
Now a days, divergences are widely used with price and an indicator, mostly made up of oscillators such as the Relative Strength Index (RSI), the Stochastics oscillator and so on.
Types of divergences
There are two main types of divergences: regular divergence and hidden divergence.
Within these two types, you then have the bullish and the bearish divergence types as well.
Regardless of what type of divergence is formed, they can signal the market correction. Note that divergences are not guaranteed. In other words, you will find a few scenarios where, despite the existence of a divergence, price continues to maintain the trend.
Therefore, it is important to use the concept of divergence alongside other technical indicators.
Example – Regular Divergence (Bullish/Bearish)
Regular bearish divergence is formed when price makes a higher high while the indicator makes a lower high. During this phase, the divergence indicates that price is likely to correct to the downside. This could either be a retracement or a reversal of the trend.
A regular bullish divergence is formed when price makes a new low but the indicator makes a higher high. This usually occurs near the tail end of a downtrend. Following this phenomenon, price can start to reverse direction and resume a correction to the upside or potentially change the trend.
The regular divergences are the most easy to trade. They signal a possible change of trend in price.
Hidden divergences on the contrary are a bit difficult to spot. These divergences indicate a trend continuation. They occur within the major trend and signal a continuation or the end of a retracement.
Example – Hidden Divergence (Bullish/Bearish)
In a way, hidden divergences are a great tool to spot the end of a correction in the trend.
A bullish hidden divergence is when price makes a higher low but the indicator makes a lower low. This marks the correction to the uptrend and upon a successful reversal following the hidden bullish divergence, you can expect price to breakout to new highs.
A bearish hidden divergence forms when price makes a lower high but the indicator makes a higher high. This hidden divergence forms during a downtrend. It signals that the upside correction in the downtrend is completed and that price is ready to continue move lower.
Traders can use both the hidden and the regular divergences to trade in the direction of the trend. These methods can help with both trend based trading as well as counter trend based trading strategies.
Almost every oscillator can be used to spot the divergence in the price. However, traders typically use the 14-period RSI or the Stochastics oscillator to identify these divergences. Sometimes, you can also make use of the moving average or Bollinger bands on the price to understand when volatility is going to rise.
Traders can also make use of Fibonacci retracement levels in conjunction with the hidden divergence in order to trade the retracements and enter the trade right at the reversal of the correction.
As we mentioned earlier, divergences are not fool proof. Although they offer a certain level of probability of success on the trades, sometimes divergences can fail. Therefore, traders should not blindly trade only with divergence but also combine with other forms of technical analysis.
It is ideal to make use of pivot points or support and resistance levels. These tend to complement divergences in a great way. You can also make use of candlestick patterns to spot the reversal candlestick patterns during these periods.
