There are many indicators and tools traders use in trying to predict the direction of price movements.
While price action itself should be the main trading tool since it provides the best picture of what is going on in the market at any given time, traders sometimes support their price action analysis with certain technical indicators to improve their predictive ability.
What they usually do is check for clues between the price action and the indicators they are using, which can enable them to make better decisions.
One of the most reliable and easily identifiable clues in certain indicators is the divergence between the price action and the indicator.
Divergence is one of our most favorite trading strategies because it often shows high probability trade setups, especially when combined with tools that indicate key price levels.
In this post, we will discuss the various types of divergence, the indicators that can show it, and how to use it in your trading. But, first, let’s find out what divergence is and why it works.
What is divergence?
To diverge means to separate or move apart. As a trading concept, divergence is said to occur when the price action differs from the movement of your momentum indicator. In other words, the indicator does not agree with the price action.
As you already know, the price moves in up and down swings (waves) — the same as your momentum indicators.
Ordinarily, the price and the indicator should be moving in the same direction at the same speed — that is, if the price is making a new high, the indicator should be doing the same, it should also be the same when the price is making a new low.
Thus, when the price action and the indicator are out of sync, you have a divergence on your chart.
In other words, the price is making a higher high, while your indicator is making a lower high, or the price is making a lower high, while your indicator is making a higher high.
On the flip side, the price may be making a lower low, while your indicator is making a higher low, or the price is making a higher low, while your indicator is making a lower low.
So, when it comes to divergence, the focus is on the swing highs and lows of both the price and the indicator you are using.
Anytime you notice that the price swings and the indicator swings don’t correlate, just know that something is going on — some form of reversal may be about to happen, even if it’s just a temporary one.
Types of divergence
From our discussion so far, if you are observant enough, you would notice that there are four different situations where you can have a divergence on your chart.
But depending on the type of price swings and the market structure, we generally classify divergence into two broad types :
Classical divergence, also known as regular divergence, occurs when the price is making a lower low but the indicator is making a higher low, or when the price makes a higher high but the indicator is not doing the same.
You see this type of divergence mostly against the prevailing trend and may indicate the reversal of impulse wave — which could become a full-blown trend reversal or a temporary pullback.
On some occasions, a classical divergence can occur with the trend if there is a deeper pullback with multiple legs. Depending on where it occurs, a classical divergence can be bullish or bearish.
Bullish classical divergence
A bullish classical divergence can occur at a price swing low, and it involves the price making a lower swing low when the indicator is making a higher low.
It is mostly associated with the end of downward impulse waves. As the name suggests, this divergence shows that an upward price reversal is likely.
Bearish classical divergence
You only see a bearish classical divergence at a price swing high, and it occurs when the price is making a higher swing high while the indicator is making a lower high.
It is mostly seen at the end of impulse waves in an uptrend. From the name, a bearish classical divergence may indicate a potential downward price reversal.
Hidden divergence is said to occur when the price makes a higher low but the indicator makes a lower low, or when the price makes a lower high and the indicator makes a higher high.
It mostly occurs in line with the prevailing trend at the end of a pullback and often indicates that the pullback is about to reverse to a new impulse wave in the direction of the trend.
Sometimes, a hidden divergence can occur at the end of the trend, along with a reversal chart pattern, such as the head and shoulder pattern or the inverse head and shoulder pattern.
This divergence can have a bullish or bearish implication, depending on where it occurs — swing high or low.
Bullish hidden divergence
A bullish hidden divergence occurs at a price swing low when the price is making a higher swing low and the indicator is making a lower low.
It is mostly seen at the end of a pullback in an uptrend, and it indicates an upward price reversal and continuation of the uptrend.
Bearish hidden divergence
A bearish hidden divergence is seen at a price swing high. It happens when the price is making a lower swing high while the indicator is making a higher high.
Seen mostly after a rally in a down-trending market, it indicates a potential downward price reversal and continuation of the downtrend
Why divergence work
There are many reasons divergence works so well in technical trading. One of them is that it may show what the big boys (institutional traders) are doing.
When the price is making a lower low or a higher high and the momentum indicator is making a higher low or lower high respectively, it could mean that the big boys are stop hunting or trying to get some traders trapped in the wrong direction, which explains why the price is still moving in that direction when there’s no momentum.
On the other hand, when the price is making a higher low or lower high and the indicator is making a lower low or higher high, as the case may be, it might be that the big boys are not interested in that swing, which explains why the price is stalling while the indicator is extending.
Another important reason why divergence work is that the price swings it occurs with often ends at key value areas in the market, such as support or resistance levels, trend lines, long-period moving averages, and Fibonacci retracement or expansion levels.
Thus, you already have a confluence of two factors — a key price level and the divergence.
Furthermore, while the indicators you use may lag the price action, divergence, in itself, leads the price — which means, most of the time, the divergence occurs before the price reversal happens.
Indicators for trading divergence
There are many momentum indicators and oscillators that give divergence signals. Some of them are based on price data, some are based on volume data, while others are derived from both price and volume data.
Some of the price-based indicators include :
The indicators derived from only volume data and both volume and price data include the following :
How to use divergence in your trading
There are different ways traders make use of divergence in your trading. Some trade it as a trading strategy on its own, probably alone or in combination with candlestick patterns.
This group of traders care less about price structures, the direction of the trend, and where the signal occurs.
While this can and do work on many occasions, we don’t advise you to randomly trade the divergence signals that way.
A better way to make use of divergence is to make it a part of a robust trading strategy. You can use it to spot a trade setup if it occurs at the right place and in the right direction or use it to indicate when to get out of a trade to avoid a pullback.
Whatever is the case, the most important thing is that you understand the position of the divergence in relation to the overall price structure, trend direction, and key price levels.
To formulate a good trading strategy with divergence, you need to make use of tools that can help you identify the trend direction, as well as the key areas of value in the market.
Some of those trading tools include trend lines, long-period moving averages, support and resistance levels, and Fibonacci levels.
One trading strategy you can use is to trade only in the direction of the trend and use divergences to confirm when a pullback has lost momentum and is about to turn to the trend direction. You can also use it as an early entry strategy in a head and shoulder pattern.
It is important to know that even when other supporting factors have aligned in your intended direction, the price diverging from the indicator is not enough to enter a trade.
You must wait for the indicator to turn and start moving in the right direction after the divergence occurred.
In other words, divergence is not confirmed until both the price and indicator have turned in the right direction — prior to that, the price swing is still at play and may end up not being a divergence.
Now, some of the ways you can use divergence to your trading advantage include the following :
Anticipate the end of a regular pullback
Here, you are using a trend-following strategy, and your aim is to enter a trade, in the trend direction, at the end of a pullback.
So, you have to identify the trend and key price levels where the pullback is likely to reverse. You are only using the divergence to confirm that the pullback has ended.
For this type of pullback with a single swing, the divergence to look out for is the hidden divergence.
Depending on the trend direction, you can either be looking for the bullish type or the bearish type.
In an uptrend, looking for bullish hidden divergence (higher swing low with a lower low in the indicator), while in a downtrend, you will have to look for bearish hidden divergence (lower swing high with higher high in the indicator).
If you want to use a divergence signal to identify a setup in an up-trending market, follow these steps :
The GBPAUD chart below is in an uptrend, as you can see from the trend line. Notice the bullish hidden divergence that occurred with the RSI when the price pulled back to the trend line.
In the case of a down-trending market, these are steps to follow:
- Use a downtrend line, Fibonacci retracement tool, or a long-period moving average
- Note previous price swing levels lying above the price, which can now act as resistance levels — it’s better if there’s a confluence with the tool you are using
- Wait for a pullback to that level to complete and check if there is a bearish hidden divergence signal
- On confirmation of the signal — with the indicator already turned downwards — go short and place your stop loss some pips above the swing high
- Manage your trade with a trailing stop if you want to ride down the trend or place a profit target
In the EURUSD chart below, the market was in a downtrend, as evidenced by the descending trend line.
When the price rallied to the trend line, the MACD made a higher high even though the price was making a lower high — bearish hidden divergence.
Anticipate the end of a deeper pullback with multiple legs
This kind of pullback can give rise to a classical bullish divergence signal in the direction of an already established trend.
With the divergence signal occurring at the right level, it could mean that the pullback has eventually ended, so you have a good setup to trade in the direction of the trend.
If you see this type of pullback in an uptrend, look for bullish classical divergence (lower swing low with a higher low in the indicator).
In a downtrend, look for bearish classical divergence (higher swing high with lower high in the indicator).
Here is how you can trade a multi-leg pullback in an uptrend :
-Make use of a long-period moving average, an uptrend line, the Fibonacci retracement tool, and also mark the previous swing points that lie below the price — each of them can show key support level
-Wait for the multi-legged pullback to reach a key support level
-Check if the various legs of the pullback created a bullish classical divergence signal
-Go long on the confirmation of the signal and put your stop loss some pips below the lowest swing low
-You can trail your profit if you want to ride down the trend or place a profit target at the next major resistance level or a Fib expansion level
In the GBPUSD chart below, you can see an up-trending market. Notice the 3 legs of the pullback to a former resistance level that became a support level.
Between the second and third leg of the pullback, a bullish classical divergence occurred with the awesome oscillator, and the price turned upwards
In the case of a down-trending market, these are steps to follow :
-You may use a downtrend line, Fibonacci retracement tool, or a long-period moving average to identify key levels but mark the previous swing points that lie above the price that can serve as resistance
-Wait for the multi-legged pullback to reach a key resistance area
-Check if the various legs of the pullback created a bearish classical divergence signal
-You can go short on the confirmation of the signal
-Put your stop loss some pips above the highest swing high and manage the trade accordingly — with a profit target or a trailing stop
The AUDUSD chart below was in a downtrend, evidenced by the down-sloping 200-period EMA.
Notice the different multi-legged pullbacks showing bearish classical divergence with the stochastic
Trade reversal chart patterns
You can use the hidden divergence signal to trade potential trend reversals if it occurs with a reversal chart pattern, such as the head and shoulder pattern or the inverse head and shoulder pattern.
Those chart patterns already indicate a possible trend reversal, but the usual entry level is when the neckline is broken.
However, a hidden divergence at the right shoulder would make a strong case for early entry at that level instead of waiting for the price to get to the neckline, especially when combined with other signals like reversal candlestick patterns.
Here is how to use the signal in a potential head and shoulder pattern :
-If the swing low preceding the right shoulder made a lower low (a sign of potential downward reversal), observe the right shoulder closely
-Compared with the head, the right shoulder is already a lower swing high (another sign of a downward reversal), so check whether the indicator is making a higher high, which would imply a bearish hidden divergence
-At this point, you should consider going short, especially if there are bearish candlestick reversal patterns, like the bearish pin bar, inside bar, or engulfing bar
-Place your stop loss above the head
-Estimate your profit target from the height of the head or ride down the emerging downtrend with a trailing stop
You can see a head and shoulder pattern in this EURUSD chart. Notice that the price made a lower low before the formation of the right shoulder (R.S), and a bearish hidden divergence occurred there. You can also see a bearish engulfing pattern at the right shoulder.
For a potential inverse head and shoulder pattern, follow these steps :
-Watch the right shoulder closely if the swing high preceding it made a higher high, which is a sign of potential upward reversal
-The right shoulder is already a higher swing low when compared with the head — another sign of an upward reversal — so check whether the indicator is making a lower low, which would imply a bullish hidden divergence
-You may go long at this point, especially if there are bullish candlestick reversal patterns, like the bullish pin bar, inside bar, or engulfing bar
-Place your stop loss below the head
-Estimate your profit target from the length of the head or ride up the emerging uptrend with a trailing stop
There is an inverse head and shoulder pattern in the EURGBP chart below. Before the right shoulder, the price made a higher high. A bullish hidden divergence occurred at the right shoulder, indicating a buy signal.
Anticipate the beginning of a pullback or trend reversal
The classical divergence signal usually occurs at the end of impulse waves and may indicate the beginning of a pullback or even a complete trend reversal. Hence, the signal can be used for any of these :
Get out of a trade
Some traders, who already have positions in the direction of the trend, may see a classical divergence occurring against the trend as an indication to close their positions before the price reverses.
They don’t want to be caught up with a potentially deep pullback or even a trend reversal, forcing them to give back all their profits.
In the GBPUSD chart below, you could see how a classical divergence can signal a time to get out of the market before a deep pullback occurred.
Fade the move
Contrarian and mean-reversion traders tend to use classical divergence as a signal to fade the price swing.
Of course, they combine it with strong support and resistance levels. When the price hits a strong resistance level, they use a bearish classical divergence signal to confirm their sell setup.
The S&P 500 Index chart below shows a bearish classical divergence that occurred with stochastic before the Covid-induced bear market started. Anyone that faded that move would have made a huge killing.
If a downswing hits a strong support level, they may fade the move with a bullish classical divergence signal.
As you can see in the EURUSD chart below, a bullish classical divergence signal that occurred with both the money flow index and the awesome oscillator lead to a reasonable upswing.
Divergence is a popular concept in technical analysis because of its superior predictive quality compared to other indicator signals.
While there are many divergence trading strategies around, which you can use, it is better to develop a robust trading strategy that suits your personality and trading style.