Divergence in Trading: A Step-by-Step Trading Guide

By Chainika Thakar

Whether you're a seasoned trader or just starting out, understanding divergence is a critical aspect of trading in the financial markets. In this blog, we will dive deep into the concept of divergence, explore its definition and various types. We'll also shed light on the crucial role played by indicators and oscillators in divergence trading.

Understanding the importance of divergence is paramount. It's a powerful tool that can help traders identify potential trend reversals or continuations. To grasp its significance fully, we'll discuss popular indicators used for detecting divergence and the mechanics behind their functioning.

As we journey through this topic, you'll discover intriguing facts about divergence trading, including historical instances where it led to significant returns. We'll also highlight common pitfalls to avoid, ensuring you trade with confidence and precision.

Moreover, we'll provide practical insights into using both regular and hidden divergences to your advantage. You'll receive a step-by-step guide for trading regular divergence and strategies for effectively identifying and capitalising on hidden divergence opportunities. By the end of this guide, you'll have a comprehensive understanding of divergence in trading and the tools to elevate your trading skills to the next level.

Some of the concepts in this blog have been taken from Technical Indicators Strategies in Python. You can take a Free Preview of the courses by clicking on the green-coloured Free Preview button.

Now, let us dig further into some of the essential topics that we have covered in this article, which are:

• Definition of divergence in trading
• Importance of understanding divergence in trading
• Types of divergences in trading
• Difference between trading with regular divergence and hidden divergence
• Popular indicators or oscillators for detecting divergence
• Step-by-step guide to trading divergence
• Common mistakes to avoid in divergence trading

Definition of divergence in trading

Divergence in trading signifies a lack of alignment between the actual price movement of an asset and the technical indicators upon which traders rely. These indicators are designed to provide estimates of an asset's price. When the price is trending downward and the technical indicator is trending upward, this disparity is termed Positive Divergence. Conversely, if the price is trending upward and the technical indicator is trending downward, it is referred to as Negative Divergence.

To illustrate, if an asset's price is consistently reaching new highs, but the indicator depicts lower lows, a divergence is evident.

Consider the example below: The market's actual price reaches a new high, but the indicator fails to follow suit. This discrepancy is indicative of a divergence.

The primary principle underlying the analysis of divergences when making trading decisions is that indicators or oscillators signal a potential reversal in the current price trend. Consequently, divergences assist in forecasting future market prices, aiding traders in making well-informed trading choices.

However, it's crucial to note that relying solely on divergences for trading decisions is not advisable.

Other vital tools, such as trend lines (including support and resistance levels), should be taken into account to validate a reversal, particularly when indicator/oscillator divergences persist over an extended period.

In the image above, you can see the Support Trend line and the Reversal Trend line.

• Support Trend line simply implies the price level that gets set for a period of time and the price of the asset does not fall below the same. For example, in the image you can see multiple instances where the price touches the support point and bounces back upwards.
• Resistance Trend line, on the other hand, is the one above which the price level of an asset does not go for a period of time. For instance, in the above image, you can see that the line acts as a point from which the prices usually reverse downwards.

Importance of understanding divergence in trading

Understanding divergence in trading is of paramount importance for several key reasons:

• Early Warning Signals: Divergence serves as an early warning system for potential changes in price direction. It can alert traders to potential trend reversals or continuations before they become apparent through price movements alone.
• Adjusting triggers: Recognising divergence helps traders manage risk effectively. By identifying potential trend reversals, traders can set tighter stop-loss orders or exit positions to limit losses. For trend continuation signals, they can adjust profit targets to maximise gains.
• Improved timing of trades: Divergence analysis can assist traders in pinpointing optimal entry and exit points. By combining divergence signals with other technical analysis tools, traders can identify more precise entry and exit points.
• Versatility: Divergence can be applied to various asset classes, timeframes, and trading strategies. Whether you're a day trader or a long-term investor, divergence analysis can be adapted to your trading style.
• Avoiding False Signals: Divergence can help filter out false signals and noise in the market. It adds a layer of confirmation to trading decisions, reducing the likelihood of entering trades based on misleading price movements.
• Strategic Flexibility: Understanding both regular and hidden divergence offers traders flexibility in their trading strategies. They can choose to trade trend reversals or continuations based on market conditions and their risk appetite.

In summary, understanding divergence in trading empowers traders with valuable insights into market trends, risk management, and entry/exit timing. It adds a layer of confirmation and versatility to trading strategies, ultimately contributing to more informed and successful trading decisions.

Types of divergences in trading

Now, let us move ahead to the types of divergences ahead.

We will categorise the types into two broad categories namely Regular (Bullish and Bearish) and Hidden (Bullish and Bearish) divergence. Okay, without any further ado, let us discuss them.

Each divergence indicates the potential price reversal.

As you can see in the images below, an oscillator shows a divergence (movement in opposite direction) from the actual price trend in the market. These divergences indicate a potential reversal in the trend.

Regular Divergence is of two types:

• Regular Bullish Divergence
• Regular Bearish Divergence

Regular Bullish Divergence

In case of Regular Bullish Divergence:

• The Indicator shows Higher Lows
• Actual Market Price shows Lower Lows

Regular Bearish Divergence

In case of Regular Bearish Divergence:

• The Indicator shows Lower Highs
• Actual Market Price shows Higher Highs

Hidden Divergence is of two types:

• Hidden Bullish Divergence
• Hidden Bearish Divergence

Hidden Bullish Divergence

In the case of Hidden Bullish Divergence:

• The Indicator shows Lower Lows
• Actual Market Price shows Higher Lows

Hidden Bearish Divergence

In case of Hidden Bearish Divergence:

• The Indicator shows Higher Highs
• Actual Market Price shows Lower Highs

Difference between trading with regular divergence and hidden divergence

Now, let us find out what is the difference between regular and hidden divergence in trading.

Understanding these divergence types assists in setting appropriate stop-loss and take-profit levels, adapting trading strategies to different market conditions, and confirming signals with other technical indicators. This knowledge enhances traders' ability to time their trades, manage risks, and ultimately improve their overall trading success.

In summary, regular divergence aims to identify potential trend reversals, making it suitable for traders looking to catch turning points in the market. Hidden divergence, on the other hand, helps traders recognise trend continuation opportunities, allowing them to stay in the direction of the prevailing trend. Both strategies require proper risk management and adherence to trading plans.

Popular indicators or oscillators for detecting divergence

Engaging in divergence trading relies on the use of indicators or oscillators to detect specific price movements in assets. As previously mentioned, these indicators unveil instances of divergence, enabling traders to base their decisions on the analysis provided by these tools. Consequently, when an indicator reveals a divergence, it serves as a potential warning sign for a price reversal in the actual market.

In all the indicator graphs below, you can see that the indicator is plotted with the values ranging from 0 to 100. Now, this means that the value can neither go below 0 nor above 100.

We will now discuss the most popular Indicators/oscillators ahead, which are:

• Relative Strength Index (RSI)
• Stochastic Oscillator
• Moving Average Convergence Divergence (MACD)

Relative Strength Index (RSI)

Relative Strength Index or RSI indicator is known to be a well-known Indicator/oscillator of Divergence, which was developed by J. Welles Wilder (1978). It helps the trader to get the relative strength of the current price as compared to the  historical closing prices of different assets over a specified period, typically 14 days. RSI also helps in verifying the entry and exit points in the market and also indicates the potential price reversal as other Indicators do.

You can see the same in the image below.

As shown in the image above, this indicator generates signals on the basis of overbought and oversold conditions. It is usually done by seeing the thresholds which are 70 and 30. You can see the working of RSI in the graph.

In case the indicator goes above 70, it implies that the market is overbought (it is a good time to sell) and may correct itself by going down. This has not really happened much after 2021. On the other hand, if it goes below 30, the asset is oversold (it is a good time to buy) and the market can retrace to the higher levels beyond this which has not happened at all in the mentioned time period.

Stochastic Oscillator

Yet another Indicator which is quite popular is the Stochastic Oscillator, which was developed by George C. Lane (in the 1950s). Traders all across the world trust this Indicator for indicating a potential price reversal. By evaluating the market’s momentum, this indicator helps by comparing the closing price with the price over a period of time. Hence, the indicator is helpful in building momentum trading strategies.

In the bullish market, it is believed that the price will generally close near the high and the opposite will happen in the bearish market, as the price will close near the low. This Indicator is based on the aforementioned assumption.

Mainly, this Indicator has two thresholds which are 80 and 20. Above the upper threshold, which is 80, the Indicator indicates that the price is overbought and it is a good time to sell. Whereas, below 20, it indicates that the price is oversold and it is a good time to buy.

Now, we will take a look at the concept of Slow and Fast Stochastic here. Slow Stochastic is known as %D, whereas the Fast Stochastic is known as %K. Here, it is important to note that %D is more significant than the %K.

Also, %K shows Fast Stochastic Line, which is the blue line and %D shows the Slow Stochastic Line, which is the orange one. Above 80, there is an overbought condition (time to sell) and below 20, there is an oversold condition (time to buy).

It should be noted here that the %K line changes its direction before the %D line. But, in case the Slow Stochastic %D changes the direction before the Fast Stochastic %K, there is an indication of a potential price reversal. Although, the price reversal will be a gradual one and not instant.

In case the Indicator reaches either 0 or 100 (which are the extremes), it implies that the price momentum is exceptionally strong in the current direction. This Indicator is highly useful in getting hold of the key reversal points and thus, is utilised for various technical setups.

Trading rules: When %K crosses above %D, a buy signal (bullish) is generated and when %K crosses below %D, a sell signal (bearish) is generated.

Moving Average Convergence Divergence (MACD)

Here, it is important to note the price movements help with relevant information when it comes to using MACD.

In simple words, Convergence implies that the trend will continue, whereas Divergence shows that a trend reversal is expected.

A Convergence and Divergence analysis requires you to analyse price changing points over a period of time. In simple words, it needs you to pay attention to the turning points in prices over a period of time.

Two main observations are:

• Are the High points for the prices rising or falling?
• Are the Low points for the prices rising or falling?

Hence, finding out the Convergence of these points as well as Divergence of the same helps you become a successful trader. In Divergence, there is always the presence of increased volatility which makes for frequent trading opportunities.

With MACD, you get to notice the instances and take out opportunities by observing and analysing them. MACD allows you to understand the market behaviour with which you can get a future estimate more accurately. In the working of this oscillator, Exponential Moving Average and Simple Moving Average are used.

Let us take a look at the graph below.

The graph shows the working of MACD. Since the typical setting keeps EMAs as 12 and 26, whereas SMA is set at 9, you can take them as it is. Or, you can choose any other values depending on the trading preference.

With this oscillator, convergence happens in case the moving averages move closer to each other, conversely, divergence happens in case the moving averages move away. Moreover, the Indicator is above 0 when the 12-period EMA (shorter period) is above 26-period EMA (longer period). Whereas, it is below 0 when the shorter 12-period EMA is below the longer 26-period EMA. This implies that positive values indicate a bullish market and negative values point toward a bearish market.

Furthermore, you can also use RSI along with another oscillator MACD. Multiple indicators are known to be more powerful together than individually as they reduce false signals.

Step-by-step guide to trading divergence

Below are the steps to trade the divergence.

Step 1: Platform Selection and Asset Choice

Select a reputable trading platform that offers access to your preferred assets, such as stocks, forex pairs, or commodities.

Step 2: Timeframe Decision

Choose a timeframe that aligns with your trading style, whether it's intraday, daily, or weekly charts.

Step 3: Indicator Selection

Pick an appropriate technical indicator for identifying regular divergence, such as the Relative Strength Index (RSI), Stochastic Oscillator, or Moving Average Convergence Divergence (MACD).

Step 4: Divergence Identification

Scan the chosen timeframe for instances of divergence. In the case of bearish regular divergence, spot situations where the price forms higher highs while the indicator forms lower highs. For bullish regular divergence, identify scenarios where the price creates lower lows while the indicator forms higher lows.

On the other hand, hidden divergence generally focuses on trend continuation, and its identification involves patterns opposite to regular divergence.

Step 5: Confirmation Strategies

Recognise that divergence alone is just a signal to exercise caution, not a direct trading signal. Confirm the potential trade with additional technical indicators, trend lines, or support and resistance levels. Look for reversal patterns that support the divergence signal (e.g., double tops or double bottoms).

Step 6: Entry Point Planning

Plan your entry point carefully. The entry point will depend on the confirmation strategies step.

Step 7: Setting Stop-Loss and Take-Profit Levels

Set triggers such as Stop Loss and Take Profits. With Stop Loss you can manage risks and with Take Profits you can secure the maximum returns. These levels should be based on your risk tolerance and the asset's volatility.

Step 8: Risk Management

Ensure your position size aligns with your risk management strategy. Avoid risking more than you can afford to lose on a single trade.

Step 9: Trade Monitoring

Closely monitor your trade's progress. Continuously assess whether the divergence signal remains valid or not.

Step 10: Exit Strategy

Exit the trade when it reaches your predetermined take-profit or stop loss level. In case the divergence signal weakens, or if the price moves against your position you must adhere to your trading plan.

Step 11: Post-Trade Evaluation

After the trade concludes, analyse its outcome. Evaluate what worked and what didn't, and use this knowledge to refine your divergence trading strategy for future trades.

Common mistakes to avoid in divergence trading

Divergence trading can be a powerful strategy, but it's not without its pitfalls. Here are some common mistakes to avoid when engaging in divergence trading:

• Ignoring Confirmation Signals: Divergence signals should not be taken in isolation. Failing to confirm divergence with other technical indicators, candlestick patterns, or trend lines can lead to false signals. Always seek confirmation before entering a trade.
• Overlooking Market Context: Divergence should be considered within the broader market context. Ignoring the overall trend or key support and resistance levels can result in poor trade decisions.
• Neglecting Risk Management: Divergence trading, like any strategy, carries risks. Failing to set appropriate stop-loss orders or risking too much capital on a single trade can lead to substantial losses.
• Not Adapting to Market Conditions: Markets are dynamic, and what works in one situation may not work in another. Traders who rigidly stick to a single divergence strategy without adapting to changing market conditions may face challenges.
• Falling for False Divergence: Not all divergence signals are created equal. Sometimes, what appears to be divergence may not be statistically significant. Avoid chasing weak or ambiguous divergence patterns.

To excel in divergence trading, traders should combine divergence analysis with other technical and fundamental analysis tools, maintain discipline, and manage risk effectively. Avoiding these common mistakes is crucial for achieving success in this strategy.

Further reads

1. How to optimise a trading strategy based on indicators
2. Five indicators to build trend-following strategies

Conclusion

As the article aimed to discuss the importance of divergence in trading and also how it can help, we have put the emphasis on its details. Apart from the basics, we covered some significant aspects where the “Facts” of the same revealed how you can make divergence useful in trading.

With a brief overview of everything important, this article covered what makes divergence profitable for you as a trader.

Hope the article helped you gain a useful insight into divergence trading!

If you wish to learn more about divergence trading, you must explore the Price Action Trading Strategies. This comprehensive course will help you build a strong foundation in price action trading. This course will help you learn to spot and trade the most important trading patterns, that is, double tops/double bottoms, triple tops/triple bottoms, head and shoulders.

Note: The original post has been revamped on 7th December 2023 for accuracy, and recentness.

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