Trading Divergences: how to interpret them?

Trading divergences are a concept used in technical analysis, which is a method of evaluating securities by analysing statistics generated by market activity, such as past prices and volume. Divergences occur when there is a disagreement between the price of a security (like a stock or a currency) and a technical indicator, usually an oscillator like the Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD).

trading divergences

What are trading divergences?

Trading divergences are a concept used in technical analysis and they occur when there is a disagreement between the price of a security (like a stock or a currency) and a technical indicator.

It's important for traders to check if these two factors are moving in sync or not. This is because when divergences occur, they can generate valuable entry signals.

Divergences occur when the price movement and the indicator go in different directions.

A bullish divergence in technical analysis happens when the price of an asset keeps falling while the underlying technical indicator starts to rise. This is seen as a bullish signal, especially if it happens when the price is near a support zone. It often comes before a price breakout.

divergences trading

A bearish divergence occurs when the price of an asset is rising, but the underlying technical indicator is shrinking. This creates a bearish signal, and if it happens when the asset is approaching a resistance zone, it often comes before a price breakdown.

Trading divergences are often used to predict changes in trends because they show that the current trend is losing steam. However, they're not always accurate and should be used along with other technical indicators to make smarter investment choices.

In technical analysis, divergences are important. You can spot them using oscillators like the Relative Strength Indicator (RSI), Moving Average Convergence/Divergence (MACD), and stochastic oscillator. In fact, these indicators give their best signals when they differ from price movement and create divergences.

Overall, the divergence signals a trend reversal. It's a difference between the price and the indicator, and it can indicate a change in the short or medium-term trend.

Types of divergences: bullish, bearish and hidden | How to identify them?

In terms of direction, there are two types of divergences: bullish and bearish.

  • The bullish divergences occur when the price action is making new lows, but the indicator shows the opposite. This shows that selling pressure is starting to weaken and a trend change may be imminent.
  • The bearish divergences occur when the price action is making new highs, but the indicator shows the opposite. This shows that buying pressure is starting to weaken and a reversal may be imminent.

While these standard divergences show a trend reversal, hidden divergences indicate the continuation of the existing trend:

  • Hidden bullish divergence: This occurs when the price forms higher lows while the indicator forms lower lows. It often suggests that the current uptrend is likely to continue. This type of divergence is often seen in a retracement during an overall uptrend.
  • Hidden bearish divergence: This happens when the price forms lower highs, but the indicator forms higher highs. It suggests that the current downtrend is likely to continue. This type of divergence is typically observed in a retracement during an overall downtrend.
divergence trading strategy

Finally, the exhaustion divergence is observed when the price of a security makes a strong move in one direction, but the momentum indicator (such as RSI, MACD, or Stochastic) fails to confirm this move. The idea behind exhaustion divergence is that even though the price is continuing to move up (in the case of a bullish trend) or down (in a bearish trend), the weakening momentum suggests that the trend is losing strength and might be nearing its end.

  • In a bullish exhaustion divergence, the price might be reaching new highs, but the momentum indicator shows weaker highs, indicating that the buying pressure is waning.
  • In a bearish exhaustion divergence, the price might be hitting new lows, but the momentum indicator displays weaker lows, suggesting that the selling pressure is diminishing.

We can use RSI divergence to identify exhausted forex pairs (as shown in the following chart). Divergence indicates that the trend waves are becoming shorter and less robust, signaling market exhaustion.

divergences trading

The divergences are typically classified into two main classes: Class A, Class B, and sometimes Class C. Each class has its own level of reliability and potential for indicating future price movements.

Class A trading divergences

Class A divergence is considered the strongest and most reliable type of divergence. In Class A bullish divergence, the price records lower lows, but the indicator shows higher lows. This suggests strong potential for a bullish reversal.

In Class A bearish divergence, the price makes higher highs, but the indicator forms lower highs, indicating a strong potential for a bearish reversal.

Class B trading divergences

Class B divergence is seen as less reliable than Class A. In Class B bullish divergence, the price forms a double bottom (two approximately equal lows), but the indicator records higher lows. This suggests some potential for a bullish reversal, but not as strongly as Class A. In Class B bearish divergence, the price creates a double top (two approximately equal highs), while the indicator forms lower highs, indicating possible bearish reversal potential.

Class C trading divergences

Finally, this is considered the weakest form of divergence. In Class C bullish divergence, the price forms lower lows, but the indicator creates double bottoms (equal lows). This suggests a weak potential for a bullish reversal.

In Class C bearish divergence, the price records higher highs, but the indicator shows double tops (equal highs). This indicates a weak potential for a bearish reversal.

In general, traders disregard classes B and C and only focus on class A. This is because both B and C are quite risky as they are not very reliable.

Divergences can be used as signal generators in several ways. One way is to simply wait for a divergence to occur and then enter a trade in the direction of the divergence. Another way is to use divergences as part of a broader strategy.

RSI divergence example

If the price of a stock is making new highs, but the RSI indicator is not, this could be a bearish divergence. On the other hand, if the price is making new lows, but the RSI indicator is not, this could be a bullish divergence.

Of course, trading divergences are just one type of signal that can be generated with technical analysis. They should not be relied upon exclusively, but they can be useful for confirming other types of signals.

Imagine a stock that initially trades at £50. Over a few weeks, the stock price declines to £45, then rebounds slightly, and then falls further to £40, creating a new low.

The RSI is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions. When the stock price first falls to £45, the RSI also drops significantly, say to a value of 30 (indicating oversold conditions). However, when the stock price declines further to £40, the RSI does not create a new low. Instead, it shows a higher low, for instance, a value of 35.

This scenario presents a Class A Bullish Divergence. Despite the stock price creating a lower low (from £45 to £40), the RSI does not follow suit and instead creates a higher low (from 30 to 35). This divergence suggests that the downward price momentum is losing strength, and a trend reversal to the upside might be imminent.

A trader observing this Class A Bullish Divergence might interpret it as a potential buy signal, expecting the stock price to increase soon.

However, it's crucial to use other forms of analysis for confirmation, such as looking for supporting patterns in the stock's price chart, evaluating market conditions, and considering any relevant news or events that might impact the stock.

Advantages and disadvantages of using trading divergences


Some analysts believe that divergences can help anticipate changes in market direction, while others see them as a tool to confirm trends. Let's now examine the advantages and disadvantages of using divergences as a signal generator.

One of the key benefits of using divergences as a signal generator is their potential to identify possible market reversals before they happen. This means that if you spot a divergence developing on your charts and open a position ahead of time, you can potentially capitalise on a favourable market move.

However, there are drawbacks to using divergences as a signal generator. One significant disadvantage is that divergences can sometimes produce false signals. Relying solely on a divergence without additional supporting indicators can lead to entering a trade that goes against your expectations.

Another drawback is that trading divergences often take time to form, potentially causing you to miss out on some potential profits if you wait for them to materialise before entering a trade.

Advantages of divergencesDisadvantages of divergences
✅ Can anticipate trend reversals❌ Sometimes they give false signals
✅ Quite simple to identify❌ Require other indicators
✅ Could help you confirm trend reversals❌ They take time to form

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Summary

In conclusion, trading divergences are frequent phenomena in trading across various time frames. This article's primary aim has been to provide comprehensive insights into these divergences, stressing the importance of an objective, emotion-free approach.

Achieving success with divergences entails patiently awaiting the emergence of divergence patterns and demonstrating discipline when adapting divergence settings. By integrating these principles into their trading strategies, traders can effectively harness the potential of divergences as valuable tools for making informed and rational trading decisions.

FAQs

Can divergences be used for short-term trading?

Yes, divergences can be used in short-term trading to signal possible price reversals by comparing price movements with indicators such as the RSI. However, they must be combined with other analytical tools to be reliable.

What is the success rate of divergence trading?

The success rate of divergence trading varies greatly depending on the skill of the trader, market conditions and the use of other methods of analysis. There is no guaranteed success rate, and effectiveness depends on execution and risk management.

How should I manage risk when trading based on divergences?

To manage risk, use proper stop-loss orders and position sizing. Divergences are not foolproof, so it's essential to have a risk management strategy in place to protect your capital.

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