Divergence in Trading: Identification, Indicators, and Practical Application

Divergence is a favorite signal among many traders. It occurs infrequently but allows market participants to determine entry and exit points, knowing when the price direction will change. Divergence is a universal signal that can be determined by various indicators. Due to this, to trade bullish or bearish divergences, you do not need to radically change your trading strategy.

This article discusses divergence and its types in detail. You will also learn ways to identify divergences using technical indicators such as MACD, Stochastic, and RSI.

What is a Divergence?

Divergence is a classic discrepancy between trend highs and lows on the price chart and indicator readings. Divergence typically indicates an imminent trend reversal.

It can be used in analysis in combination with any market research methods, such as Price Action and indicator analysis. Depending on the trend line's direction, divergences are divided into bullish and bearish.

Convergence is the opposite of divergence. In this article, all convergences and divergences of the price direction and technical indicator are referred to as divergence.

What is Bullish Divergence?

A classic bullish divergence forms before an upward reversal of the current trend. It occurs when the price chart forms a new low while an indicator, like the relative strength index (RSI), tends to rise. Bullish divergence indicates a potential shift in market sentiment to bullish.

Hidden bullish divergence, on the other hand, signals trend continuation. It occurs when the price chart shows increasing lows, while the indicator window shows decreasing lows. After this signal forms, the bullish trend is likely to continue.

What is Bearish Divergence?

Bearish divergence signals that the trend is weakening and an upward direction will soon reverse. It occurs when a new high is formed on the price chart, but a smaller high is observed on an indicator such as the Stochastic Oscillator.

Hidden bearish divergence, meanwhile, occurs during downtrends. It suggests that reversal signals are false and that the downward trend will continue.

How to Identify Bullish and Bearish Divergence

To identify divergence, a prolonged trend and specific price-action patterns, such as double bottoms for bullish divergence, are necessary. Signal lines drawn from extreme points on the price chart and the chosen indicator (e.g., RSI, MACD) should show opposing slopes to confirm divergence.

When using indicators like MACD, divergence can be identified either from the signal line or histogram columns. For example, a divergence occurs when prices form lower lows while the MACD histogram shows higher lows.

Bullish and Bearish Divergence Trading Indicators

MACD

The MACD indicator shows the convergence and divergence of moving averages. Divergence can be plotted using either the MACD signal line or its histogram. A bullish divergence occurs when the price forms lower lows while the MACD histogram forms higher lows, suggesting an upward reversal.

Stochastic Oscillator

The stochastic oscillator measures the current price relative to its price range over a selected time period. Divergence is identified when the price and oscillator lines show opposing trends. For example, a bearish divergence occurs when the price forms higher highs, but the oscillator forms lower highs.

RSI

The RSI is widely used for identifying divergence. It compares positive and negative price changes to identify trends and reversal points. Divergence is confirmed when the RSI line shows a trend opposite to the price chart.

Bollinger Bands

Bollinger Bands are trend indicators consisting of a moving average and standard deviations that create a price channel. They can help filter and confirm divergences identified by other indicators, such as RSI or Stochastic.

Conclusion

Divergence is a powerful trend reversal and continuation signal applicable across time frames and markets, including cryptocurrencies, currency pairs, and stocks. Its primary advantage lies in being a leading indicator.

However, relying solely on divergence for trading is risky, as it can often give false signals. Integrating divergence with other technical tools and strategies can improve accuracy, enhance forecasting, and reduce risk in trading.