Divergence Pattern in Trading: Why Investors Need to Know

Finding turning points in trends is one of the biggest challenges for investors in financial markets. Divergence patterns are tools that help you determine whether the current price trend still has genuine support or is weakening. Being able to correctly identify and apply divergence patterns is key to improving your trading strategies.

Contradiction Patterns: The First Signal of a Trend Change

In a broad sense, divergence patterns refer to situations where the market price moves in one direction, but technical indicators do not confirm that movement.

This often occurs in four main cases: (1) the price makes a strong low, but the indicator does not show bearish strength, signaling a potential bullish move; (2) the price makes a strong high, but the indicator does not confirm the bullish move, signaling a potential bearish move; (3) the price swings lower, but the indicator still shows a downtrend; and (4) the price swings higher, but the indicator still shows an uptrend.

Recognizing divergence patterns is important because it helps you understand whether the observed trend has real support. If not, there’s a chance of a price reversal.

Regular Divergence Pattern: Trading Opportunities When the Trend Slows

Regular divergence pattern (or general divergence) occurs when the price moves strongly in one direction, but the indicator does not strictly confirm that strength. This often indicates that the current trend is losing momentum.

Bullish Divergence Pattern

Bullish divergence pattern typically appears at the end of a downtrend. The price creates a new lower low, but the indicator starts not to follow — it forms a higher low (or no new low at all).

This suggests that although the price has dropped further, selling momentum is decreasing. Sensitive investors often wait until the candlestick turns green before entering a buy position.

Bearish Divergence Pattern

Conversely, bearish divergence pattern occurs at the end of an uptrend. The price makes a new higher high, but the indicator forms a lower high (or no new high).

This indicates that even though the price continues upward, buying strength is waning. This signal is often used to prepare for a short position.

Hidden Divergence Pattern: Confirmation of Continuation

Hidden divergence pattern is entirely different. It does not indicate a trend reversal but confirms that the current trend is likely to continue.

When the price oscillates in cycles but the indicator continues to show support, it signals a hidden divergence pattern, suggesting the original trend will resume.

Hidden Bullish Divergence Pattern

Hidden bullish divergence pattern occurs when the price makes a “Higher Low,” but the indicator forms a “Lower Low.” This suggests that the price appears weak, but the indicator is positive — meaning the uptrend is likely to continue.

Hidden Bearish Divergence Pattern

Similarly, hidden bearish divergence pattern occurs when the price makes a “Lower High,” but the indicator forms a “Higher High.” This indicates that although the price is starting to decline, the downtrend still has momentum to continue.

Reading Divergence Patterns with Popular Indicators

Detecting divergence patterns requires knowing what to look for in indicators. The most commonly used indicators include:

MACD (Moving Average Convergence Divergence): This indicator uses two moving averages to track momentum. When MACD is positive and rising, it supports an uptrend; when negative and falling, it supports a downtrend.

RSI (Relative Strength Index): Measures buying and selling strength. An RSI above 70 indicates an overbought market, often signaling weakening prices; below 30 indicates oversold conditions.

Williams %R: Similar to RSI but scaled 0-100. Values above 80 suggest overbought conditions; below 20 suggest oversold.

Trading Strategies for Divergence Patterns in Real Situations

Trading Regular Divergence Pattern

When you identify a regular divergence pattern, follow these steps:

1. Identify reference points: Look for higher highs or lower lows in price and see if the indicator confirms these points.
2. Wait for confirmation: Don’t open a trade immediately. Wait for confirmation signals, such as candlestick color change or price breaking key levels.
3. Set stop-loss: For bullish divergence, place stop-loss below the previous low; for bearish divergence, above the previous high.
4. Determine profit targets: Use resistance/support levels or trendlines to set profit targets.

Trading Hidden Divergence Pattern

For hidden divergence, focus on trend continuation:

1. Confirm the current trend: Determine if it’s an uptrend or downtrend.
2. Look for divergence confirming continuation: During pullbacks, find hidden divergence patterns that support the trend’s persistence.
3. Enter in the trend direction: Buy in an uptrend or sell in a downtrend when hidden divergence appears.
4. Manage risk: Set stop-loss at pullback levels and allow room for profit to run.

Dangers of Relying Solely on Divergence Patterns

While divergence patterns are useful, there are important cautions:

Divergence patterns are not 100% accurate: Price can form divergence multiple times before a real reversal occurs. Sometimes divergence appears without a subsequent trend change.

Use with other tools: Smart traders do not rely solely on divergence. Combine it with other analysis methods like support/resistance levels, trendlines, or candlestick patterns.

Manage risk: No matter how promising a divergence pattern looks, always set appropriate stop-losses and follow sound risk management principles to avoid significant losses.

Summary

Divergence patterns are valuable analytical tools for investors seeking to understand trend changes. Whether aiming to catch reversals (via regular divergence) or confirm trend continuation (via hidden divergence), a deep understanding of divergence patterns enhances your confidence in trading decisions.

However, do not overly rely on divergence patterns alone. Use them alongside other technical analysis tools and proper risk management to make your trading more effective and reduce long-term losses.