Introduction
In trading and especially stock trading at that you have to know the ins and outs of the current conditions regarding your favorite stock like whether it’s poised for a resurgence or a correction.
But if you’re a newcome,r no doubt you’ll be scratching your head a lot at those charts or indicators and be like how do I even know the stock is going to rise or will rise?
The answer to that is you will know it if you know what to look for and that could be either crossovers or divergences the latter of which will be receiving the attention here.
What is Divergence in Technical Analysis?
So what is divergence even about in stocks?
Simply put if you see the price go a certain way whether really high or really low but then the indicator paints something else that doesnt reflect that then you have a divergence on your hands.
Still dont get it? No need to worry as we’ll explore those details a bit more below.
The Importance of Divergence in Trading
So why is divergence so important for so many traders out there? The reason for that can be made clear through a simple imaginative exercise.
Imagine if you know that the price is going to rise or fall eventually once you see a certain circumstance happening and there’s no doubt about it in your head.
What could you do with that information? You could do so much right? All the more if the price goes even more favorably your way.
You could buy when the price is set to rise and sell if it’s set to fall among various other things.
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Understanding Divergence
There are multiple layers of understanding when it comes to divergences besides just knowing what it is obviously.
You have different types of divergences of course and how they relate to the price and getting a handle on those can be very important if you want to broaden your understanding of this mechanism or concept.
Definition of Divergence
First things first if you want to have even a basic understanding of divergence you must have the definition of it set in your head.
While we already went through what it is earlier we’ll be a bit more specific this time as in divergence happens when the price and the indicator go opposite ways and depending on how they diverge you get a couple of types which we’ll look at below.
Types of Divergence
There are usually two main kinds of divergence that you’ll get to deal with for the most part and these are the regular or classic divergence and the hidden divergence.
Regular (Classic) Divergence
So the two regular types of divergence happen to be your straightforward bearish and bullish divergence.
Bullish divergence happens when the asset’s price goes through lower lows but the indicator shows higher lows.
This discrepancy just means that while the price is declining the momentum behind that downward movement is declining as well which could just mean that there’s a possible exhaustion among sellers.
On the other hand bearish divergence happens once an asset’s price undergoes higher highs but the indicator shows lower highs.
While that price is rising its momentum that’s behind that upward movement is growing weaker which indicates a potential exhaustion amidst buyers this time.
Bearish divergence is usually a means to foreshadow downward price reversals which implies potential selling opportunities for traders seeking to benefit from those impending downtrends basically.
Hidden Divergence
Hidden divergence is not as well known but nonetheless it can be a powerful concept within technical analysis that has to do with discrepancies between price movement and indicator directions.
This form of divergence shows a continuation of current trends instead of reversals.
And unlike your traditional divergence where indicators go opposite the price hidden divergence happens when indicators actually align with those price trends but the momentum underlying it is different.
There are two types of hidden divergence too which like the regular one include both the bullish and bearish iterations.
Bullish hidden divergence then occurs when prices show higher lows whereas the indicator shows lower lows.
Bearish hidden divergence happens when the prices form lower highs with the indicator forming higher highs.
Hidden divergence signals can be very valuable for traders since they offer that early indication of a continuation of trends.
Such a phenomenon only serves to suggest that though prices may exhibit some temporary pullbacks or even rebounds the underlying momentum that supports the trend is not going anywhere.
Therefore having an understanding of hidden divergence simply empowers you as a trader to have a better interpretation of market dynamics and with that you could then make some nice trading decisions.
How Divergence Works
By now you must have a fair understanding on what divergence means within the context of stock trading so let’s now condense all of that to the main bits and see how the thing works once more.
The Concept of Price Action and Indicators
As you must have understood by now the concept of price action and its relation to indicators forms a crucial role in discerning that divergence.
So depending on how the price moves and if you see the indicator reacting differently then you may have a divergence on your hands which could either imply a reversal or a continuation of the trend.
Identifying Divergence on Charts
Charts are like your number one friend when it comes to those divergences otherwise how will you even find them out if you dont plan on using one?
As such trading platforms will offer you all manner of charts for you to use at your disposal whether it be candlesticks or those simple bar charts.
Key Characteristics of Divergence
Here we’ll be looking at some of the key characteristics underlying divergences that you should know about.
Bullish vs Bearish Divergence
Bullish divergence is supposed to show this weakening in selling pressure whereas bearish divergence implies a lowering buying interest with a possible shift towards more selling pressure.
Other than that the two are also different in terms of when entry or exit points are to be placed for certain trades.
Bullish divergence tends to offer early signals of possible trend reversals whereas bearish divergence may serve as this early warning that you might be getting an impending downward reversal.
Timeframes and Divergence
The second thing is that you can use divergences with multiple time frames though they may be more effective with some and less with others.
Using Divergence in Trading
By now you must have a good idea of what divergences are and how they work so now you may want to get into the more practical end of things and know how you could actually use them in your trading.
Divergence as a Trading Signal
One of the more obvious use cases of it has to be using it as a trading signal of sorts to determine when to enter or exit a trading position.
Combining Divergence with Other Indicators
By default divergence is determined when you use an indicator so you cant just rely on the price alone.
But sometimes you may want to combine two or more similar indicators together to see if divergence is appearing on more than one or all of them.
Risk Management with Divergence Trading
Another obvious use is managing your risk with divergence in that if you know its a bearish divergence then you may want to exit soon since the market may take a turn for the worst.
Popular Indicators for Divergence Trading
So you need to use an indicator for your divergence trading but the question is what indicator will you or can you use?
Below we’ll be looking at some of them.
RSI (Relative Strength Index) Divergence
The RSI should need no introduction as it is one of if not the most widely used or popular indicators out there and you can be sure that it would be a well fit here.
MACD Divergence
The Moving Average Convergence/Divergence is another momentum indicator that you can use here.
Stochastic Oscillator Divergence
The Stochastic Oscillator is comparable to the RSI and likewise it’s another popular indicator that’s used to find out divergences.
Advanced Divergence Concepts
Lets look at some advanced divergence concepts here that you may want to factor in when trading.
Multiple Timeframe Divergence Analysis
One advanced method is to use several time frames in your divergence analysis to increase your chances of finding and acting upon one.
Divergence Strength and Reliability
Another concept is to assess the strength and reliability of your divergence signal and this is something that you can do by seeing if it’s there on other indicators or you could just increase the time frame as longer time frames may produce more accurate divergence signals due to the less noise.
Advantages and Limitations of Divergence Trading
Knowing both the pros and cons of things is always good to make the most out of your trading.
Benefits of Using Divergence
Well it can be a decent way to determine if a reversal is going to happen or whether the trend is continuing and it just about works with most indicators.
Potential Drawbacks and False Signals
The possibility for false signals is still there so be on the lookout for those and try your best to improve accuracy.
Cryptocurrency Trading with Divergence
Cryptocurrencies are like securities anyways with how they function so you can trade some crypto using divergence strategies as well.
Tools and Software for Divergence Analysis
Outlined below are some popular tools and software that you may use for your divergence analysis
Popular Charting Platforms
These include the likes of TrendSpider, Benzinga, TradingView and eToro and MetaTrader 4
Divergence Indicators and Scanners
Besides the indicators we’ve already gone through there are plenty of others you may use to find out divergences like your standard moving averages like SMA, EMA and WMA and there’s even the Awesome Oscillator.
Conclusion
The role that divergence can play cannot be understated as it can be an integral step to make a more comprehensive trading strategy.
And as more inventive and unique indicators pop up you can be sure that divergences are likely to see some form of evolution or another.
What is the difference between regular and hidden divergence?
Hidden confirms trend continuations whereas the regular shows that a reversal is going to happen.
How reliable is divergence as a trading signal?
It can be very reliable depending on the steps you take to improve its accuracy.
Can divergence be used in all markets?
Not really as you may not find it as prevalent within flat markets.
How can I avoid false signals when trading with divergence?
Use multiple indicators with longer time frames if you can afford it.
Is divergence more effective in certain timeframes?
It may be more effective with longer time frames
