Divergence is the gold signal for professional traders

Divergence is a financial phenomenon that occurs when price movements and signals from technical indicators do not point in the same direction. This condition serves as a valuable warning to traders because it indicates that the apparent trend may not be as strong as it seems, or that the trend may continue depending on the type of conflicting signals present.

Understanding Divergence Before Trading

Divergence is a mismatch between price and an indicator calculated from market data. Normally, when prices create higher highs, the indicator should show increasing momentum. Similarly, when prices make lower lows, the indicator should confirm decreasing momentum. However, when divergence occurs, the situation is different.

Understanding divergence is important because it helps traders spot potential reversals before the price shows a clear turnaround. This signal acts like a “bell ringing” that indicates something is changing behind the scenes.

MACD, RSI, and Williams %R: Tools for Reading Divergence Signals

Most traders use oscillators to detect divergence signals, which are designed to measure the strength of price momentum.

MACD (Moving Average Convergence Divergence) is a key tool calculated from two moving averages. When MACD is positive and rising, it indicates an uptrend. Conversely, when MACD is negative and decreasing, it signals a downtrend. MACD divergence occurs when prices reach new highs/lows but MACD does not follow suit.

RSI (Relative Strength Index) measures the speed and change of price movements. Generally, RSI above 70 indicates overbought conditions, while RSI below 30 indicates oversold conditions. RSI divergence in these zones is a notable signal.

Williams %R functions similarly to RSI, using a scale of 0-100 to identify overbought and oversold conditions. Values above 80 or below 20 can signal potential divergence.

Regular Divergence vs Hidden Divergence: Different Terms

Correct divergence analysis requires distinguishing between two types, as each indicates different things.

Regular Divergence (Bullish and Bearish) signals weakening trends. Regular Bullish Divergence occurs when prices make lower lows but the indicator does not confirm, suggesting a potential reversal upward. Regular Bearish Divergence happens when prices make higher highs but the indicator shows weakening momentum, hinting at a possible reversal downward.

Hidden Divergence (Hidden Bullish and Bearish) indicates trend continuation. Hidden Bullish Divergence appears when prices form higher lows while the indicator shows lower lows, suggesting the upward trend will continue. Hidden Bearish Divergence occurs when prices make lower highs but the indicator moves higher, indicating the downtrend may persist.

How to Spot Signals and Trade

For Regular Divergence: Start by analyzing price patterns or “gaps.” Look for situations where prices are making new highs or lows while the indicator enters overbought or oversold zones. These are prime moments for divergence signals.

When a signal appears, confirm with candlestick patterns. For example, for Regular Bullish Divergence, wait for a long green candle and enter the trade without going too deep. Place stop-loss below the previous swing low, and target moving averages or key resistance levels for profit.

For Hidden Divergence: The approach differs slightly. It’s not about reversal but trend continuation. When you see Hidden Bullish Divergence, wait for a breakout above resistance before entering. Expect profits from the ongoing trend.

Important Cautions

Divergence is a useful indicator but does not guarantee profits. Signals can appear multiple times before the price moves as expected. This phenomenon is called “Divergence Failure” and can lead to losses.

A key rule is to manage risk properly when using divergence. Always set reasonable stop-loss points and avoid increasing position size on a single trade. Also, do not rely solely on divergence signals; confirm with other analysis tools like support/resistance levels or trend lines.

Summary

Divergence is a smart analytical tool for predicting technical changes. Its ability to warn traders before price reversals makes it highly valuable. By practicing correct identification of Regular and Hidden Divergence and integrating risk management strategies, traders can improve their understanding of market movements and potentially generate profits from market uncertainties.