What is Divergence?
Divergence is when the price of the specific asset moves in the opposite direction as to what the technical indicator, such as RSI and MACD, indicates.
There are two types of divergence:
- Regular Divergence – Regular Divergence occurs when the price action makes higher highs or lower lows. This trend indicates the possibility of a trend reversal. However, when a trend reversal would occur it cannot tell. Regular Divergence can be bullish and bearish.
- Hidden Divergence – Hidden divergence occurs when the indicator makes a higher-high or lower-low while the price action does not. This means that the ongoing trend is strong and will continue in the near future. Hidden Divergence can be bullish and bearish both
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Further Categories of Divergence are:
Bullish and Bearish Divergence
- Bullish Divergence – This occurs in a down-trend when the price action prints lower lows that are not confirmed by the oscillating indicator. This shows a weakness in the down-trend since selling is less urgent or buyers are emerging.
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The below chart shows the graphical representation of bullish divergence on a chart
- Bearish Divergence – This occurs in an up-trend when the price action makes higher highs that are not confirmed by the oscillating indicator. This shows a weakness in the uptrend since buying is less intense and selling or profit-taking is increasing.
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The below chart shows the graphical representation of a bearish divergence on a chart
Integrating the above categories of divergence, we get four types of divergence. They are as follows:
- Regular bullish divergence – This type of divergence occurs when the price swing is making a lower low while the oscillator is making a higher low. It mostly forms after a prolonged downtrend or a multi-legged pullback in an uptrend, and it is a bullish reversal signal.
- Regular bearish divergence – This type of divergence occurs when the price is making a higher swing high while the indicator is making a lower high. It occurs mostly when the price has been in an uptrend for a long time, and it gives a bearish reversal signal.
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- Hidden bullish divergence – This type of divergence occurs when the price is making a higher swing low while the oscillator is making a lower low. It is seen mostly when there is a pullback in an uptrend, and it gives a bullish signal, marking the likely end of the pullback and a continuation of the uptrend. Robotic stocks offer an exciting investment opportunity for traders.
- Hidden bearish divergence – This type of divergence occurs when the price is making a lower high while the oscillator is making a higher high. It is seen mostly when there is a pullback (a price rally) in a downtrend; it gives a bearish signal, marking the potential end of the pullback and a continuation of the downtrend.
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Investors use divergence for mainly two purposes:
- To identify the momentum of asset price
- To identify the possibility of a reversal
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How to do Spot Divergence in Trading?
Traders should be aware of the following key factors before entering a trade.
- In order to spot divergence, it is important to be working with at least two variables. There are many technical indicators that can be used such as the RSI indicator.
- Next, traders should look for situations where the RSI indicated a trend reversal such as from a downtrend to an uptrend.
- Now, find and analyze the corresponding area on the chart and spot divergence such as a market high followed by a slightly higher high.
- Lastly, traders should be able to identify the different price actions that can cause divergences.
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How to Trade with Divergence?
Spotting divergence is crucial to making better decisions while trading. Here are a few tips to understand while trading with divergence:
- Entering the trade at the right time is one of the most important factors. For this traders need to tread with patience in order to look for confirmation from the price action. The price confirmation occurs when the price goes beyond the trendline. Another key entry point is when the price breaks support and resistance levels. Whenever traders spot any of those confirmations, it is always the right time to enter the trade. If you are seeking a steady stream of income, you should invest in REIT stocks.
- Traders can place a stop-loss above the top and below the reversal’s bottom. This allows them to be on the safe side to stay away from any surprise price movements.
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How to Use Divergence in Trading?
Here are some tips that can help traders make good use of divergence in trading:
- Consider the Price scenario – For a divergence to exist, the price must form one of the following:
- A lower swing lows
- A higher swing high
- A higher swing lows
- A lower swing high.
The corresponding indicator swing, on the other hand, must be out of sync with that of the price. Divergence cannot be confirmed if none of the above scenarios in the price plays out.
- Check the trend – It is important to draw trend lines. This helps traders easily visualize the trend and how the price swings relate to each other. Investors who are looking to benefit from the rising technology by earning profits should consider drone stocks for investment.
- Wait for the indicator to turn – Which every indicator the traders are using to spot divergence, it is important to wait for the indicator to turn in the direction of the signal. For a bullish signal, the indicator must turn upward, and for a bearish signal, the indicator must turn downward.
- Do not go after every signal: Some divergence signals would require trading against the trend. While a divergence signals a decrease in momentum, it may not necessarily lead to a price reversal. Therefore, it is also important to know that missing a specific opportunity will not do any harm. Because there will be more opportunities so just be patient and wait for another opportunity to present itself.
- Be careful – Divergence signals are more accurate when seen on higher timeframes compared to shorter timeframes, so look for it on a higher timeframe
- Be careful about the trade volume – Traders can use the volume to confirm a divergence signal. The volume will typically indicate the level of activity in the market at that moment, so it can confirm a decline in price momentum
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Divergence in Technical Analysis
During technical analysis, divergence is an indicator of positive or negative price movement.
For a positive divergence, the price of an asset will dip to a new low, while the indicator that tracks this asset will indicate patterns of climbing.
Negative divergence is when the price of the asset climbs to a new high, while the indicator, such as an oscillator, forms a lower high or begins to show signs of slowing down, such as the beginning of a downtrend. Investing in fintech stocks is a smart investment move today.
Divergence Trading Strategy
A divergence trading strategy requires that traders pay attention to both the indicator and the price movement
Hidden divergences have the potential to increase chances of success, provided that the investor is able to spot trades that are moving parallel to the trend. Hidden bullish divergences can be seen in oversold areas during an uptrend. It is recommended that traders use the previous oscillator low to determine whether prices are too high. Also, agricultural stocks offer excellent opportunities for investors.
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Which Indicator is Best for Divergence?
RSI for trading divergence
The RSI indicator is a momentum indicator. On a chart, it is plotted as an oscillator between 0 and 100 under the candlestick chart. The RSI is calculated by averaging the price gains and losses over the previous 14 periods.
The indicator creates a smooth line that tracks the trend in the price and lends itself well to divergence trading. The RSI indicator provides overbought and oversold readings. While there might be fewer signals when using divergence for trading signals, these signals carry more weightage in reliability.
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MACD for divergence trading
MACD is a momentum indicator that is used in trend-following markets. The trend indicator plots a signal line as well as a histogram that shows the difference between two moving averages. The moving averages will converge and diverge as the trend progresses and eventually reverses.
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In MACD there is no pre-defined area of overbought and oversold in the MACD. Therefore, this indicator has the limitation that selecting which trend trade signals are reliable is difficult. However, using previous peaks on the MACD effectively as areas of support and resistance can be helpful. Because it is best used in trending environments, the MACD will produce many false signals counter-trend.
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Stochastic for trading divergence
Stochastic is a momentum technical indicator. It operates by comparing the last closing price with a range of previous prices over the last 14 periods. Go through the list of the best forex indicators that are constructive in making disciplined and informed decisions.
This technical indicator is comparatively more sensitive to market and price swings. Therefore, it will offer more divergence signals which means more trading opportunities. However, traders need to watch out for more false signals. It’s always wise to limit your exposure to risky investments like the best altcoins.
CCI (commodity channel index) for trading divergence
The Commodity Channel Index (CCI) is a momentum-based oscillator. It measures the difference between the current price and the historical average price. This momentum-based oscillator is used to help determine when a stock price is reaching a condition of being overbought or oversold. The indicator oscillates about the zero level and can give divergence signals.
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How do you Confirm Divergence?
Below are some of the popular methods adopted by traders which help reduce the number of false signals and improved the chances of profitable trades:
- Only take divergence signals that are moving in the direction of the long-term trend. For example, when the market is bearish, only pick bearish RSI signals. Vice versa when the market is bullish, only pick buy signals from the RSI
- Wait for the candle that is confirming the divergence to close. Indicators provide signals according to the current state of the candle. If the candle closes differently, a trading signal from divergence can disappear as quickly as it appeared.
- Use supporting indicators to confirm the signal such as support and resistance levels, round numbers, pivot points, or a price action trading pattern.
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Is Trading Divergence a Profitable Trade?
Yes. Trading divergence is profitable. However, with the stock market, nothing is permanent and nothing can be predicted with full conformity. Also, with indicators, it is important to note that these indicators filter the price movements. They can help us figure out what is important and sometimes even miss important opportunities. Get to know the best uranium stocks to invest in now.
Advantages of Divergence Trading
One of the key advantages of using divergence in trading is it assists the traders in timing their trades. It gives the signal before the price trend has changed. This early signal gives the trader a better entry price for their trade.
Also, it is easy to understand and it works in every environment and market. Divergence trading also provides traders with good signals which warn of changes in the strength of the trend. Check out some of the best recession stocks to buy now.
Disadvantages of Divergence Trading
On the other hand, one of the key disadvantages of using divergence is that it can give false signals. This happens when the indicator changes direction but the price trend does not reverse as the indicator suggested.
Another disadvantage is that divergences depend upon indicators, Therefore, divergences may or may not form in the same market. It depends on the indicator traders are using and its settings.
Also, divergencies ignore the trade volume. Trade volume relates directly to the driving forces in the market: the forces of supply and demand.
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CONCLUSION
Divergence is an easy and handy technical analysis concept that can help in risk management and timing of the trade. However, combining divergence with other tools is advised to get accurate results.
Divergences are one of the most important and commonly used concepts in technical analysis. It is the difference between the indicator and the price action. Divergences indicate many things such as it indicates positive or negative movements in stock prices.
There are several indicators like the relative strength index (RSI) that can help identify divergence. However, it is important to move with patience in trades and only enter the trade upon confirmation. With enough experience in divergence trading, it can give traders good profits with the proper application at the very right place.
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