Why is Experience in Divergence Trading a Must?

15 min read

By Chainika Thakar

Divergence is one of the most important factors when it comes to being decisive about executing the trade. But, there are other important factors also that you, as a trader, must look into while making a trading decision. We will discuss those factors very briefly ahead in the article.

Although, with an experience in Divergence Trading, you will understand the practicality of its role which is quite profitable. Here, we will go through all the important aspects like its meaning, types, indicators, facts and the uses that actually prove its worth. Also, there are some order types which help you make the best decisions based on your analysis. We will discuss everything from analysing the stock prices, forecasting them, and then using the most relevant order type to execute the order.

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

Divergence in Trading: Meaning and Types

Divergence in trading implies the non-synchronization between the movement of actual prices of an asset and the technical Indicators which you relied on. Technical Indicators are meant to help you get an estimate of the price of an asset. In case the movement of the price is lower and the technical Indicator is moving higher, the mismatch is known as Positive Divergence. Conversely, if the movement of the price is higher and the technical Indicator shows a lower movement, it is known as Negative Divergence.

To be precise, for instance, if the price of an asset is making new higher highs, whereas, the Indicator is showing lower lows, there is a Divergence.

One of the examples of Divergence is the image below. It shows that the Market (Actual price) has made a new high but not the Indicator. Hence, the Indicator shows a Divergence.

Source: Wikipedia

The main theory behind studying the Divergences while making a trading decision is that the Indicator/Oscillator indicates a reversal in the actual price that may happen soon. Hence, Divergences help in estimating the market price in future so that you can make the right decision with regard to trading.

But, another important point is that you must not base your trading decision entirely on Divergences. There are other essential tools you must consider as well, like Trendline (Support level and Resistance Level) to confirm the reversal. This is especially applicable in case the Indicator/Oscillator Divergence occurs for a prolonged period.

Source: Wikipedia

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

  • Support Trendline 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 instance, in the image, there are different price levels at different time intervals (years) on the Support Trendline below which the price does not fall.
  • Resistance Trendline, 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, different price levels are shown for different years above which the price of the asset does not go.

Now, let us move ahead to the Types of Divergences ahead.

Divergences indicate a potential Bullish (an uptrend in the price) market or a potential Bearish (a downtrend in the stock price) market and hence, mainly these are the only types. But, there is a twist of both (Bullish and Bearish) being of two types further.

That is why we will categorise them into two broad categories namely Regular (Bullish and Bearish) and Hidden (Bullish and Bearish) Divergence. Okay, without any further ado, let us discuss them.

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 Regular Bearish Divergence:

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

We have attempted to make the understanding clear with the image below depicting the movements of trend. There are two rows namely, “Price” and “Oscillator” and each column has each type of Divergence showing the opposite movement of Oscillator from the Price or “Divergence of Oscillator from the Price”.

Each Divergence indicates towards the potential price reversal.

Source: orbex

As you can see in the image above, 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.

In the first column Regular Bearish Divergence is noted when the actual price in the market makes Higher Highs but the Indicator makes Lower Highs (downtrend).

Second column shows Regular Bullish Divergence as the actual price in the market makes Lower Lows but the Indicator makes Higher Lows (uptrend).

Third column shows Hidden Bearish Divergence which occurs when the actual price in the market is making a Lower High but the oscillator is making a Higher High (downtrend).

And, the fourth column shows the Hidden Bullish Divergence which occurs when the actual price in the market is making a Higher Low but the oscillator is making a Lower Low (uptrend).

As we have discussed the types, we will learn about the uses of the same later in the article.

Let us now move forward and find out about the Indicators/Oscillators in Divergence Trading.

Indicators/Oscillators in Divergence Trading

Trading in Divergences requires Indicators/oscillators for indicating a particular movement of the price of the asset. As we mentioned earlier, Indicators reveal the Divergence, and hence, the trader is able to make decisions based on the analysis by them. Hence, when any Indicator shows a Divergence, there may be a warning of a price reversal in the actual market. When the actual price shows a Higher high and Indicator shows a Lower High, it indicates towards a Regular Bearish market. Conversely, if the actual price shows a Lower low and Indicator signals a Higher low, it is a Regular Bullish market. 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 (RSI) 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 previous day’s closing prices of different assets. RSI also helps in verifying the entry and exit points in the market and also indicates the potential price reversal as other Indicators do. Also, by default, RSI is calculated across a fourteen-day period.

This Indicator lets you know when to buy the asset and when to sell. It is usually done by seeing the thresholds which are 70 and 30. You can see the working of RSI in the graph below. 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. 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.

Source: Wikipedia

Furthermore, it has been observed that RSI and another oscillator MACD are known to be more powerful together than individually.

Stochastic Oscillator

Yet another Indicator which is quite popular is the Stochastic Oscillator, which was developed by George C. Lane (in 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. In the bullish market, it is believed that the price will generally close near the high and 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.

Source: Wikipedia

In the graph above, 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. Also, %K shows Fast Stochastic Line, which is the Blue line and %D shows the Slow Stochastic Line, which is the Red one. Above 80, there is an overbought condition (time to sell) and below 20, there is an oversell condition (time to buy).

It should be noted here that the %K line changes its direction before %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. In case the Indicator reaches either 0 or 100 (extremes), a strong move is indicated. This Indicator is highly useful in getting hold of the key reversal points and thus, is utilised for various technical setups.

Point to Note: 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 profit gainer. In Divergence, there is always the presence of increased volatility which makes for frequent profitable opportunities.

With MACD, you get to notice the instances and take out profitable 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 Averages and Simple Moving Average are used. Let us take a look at the graph below:

Source: Wikipedia

The graph shows the working of MACD. Since the classic 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 of 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.

Real-World Example

Ahead you can take a cue from a real-world example of Dow Jones as to how the performance of the market can be concluded on the basis of forecasting oscillators we just discussed.

On March 25, 2020, in the current scenario of Coronavirus outbreak, According to livetradingnews.com, ”DJ INDU AVERG is currently 23.3% below its 200-period moving average and is in a downward trend. Volatility is extremely high when compared to the average volatility over the last 10 periods. There is a good possibility that volatility will decrease and prices will stabilize in the near term. Our volume indicators reflect moderate flows of volume out of DJI (mildly bearish). Our trend forecasting oscillators are currently bearish on DJI and have had this outlook for the last 21 periods. Our momentum oscillator has set a new 14-period high while the security price has not. This is a bullish divergence.”

Ahead, let us take a look at the Interesting Facts About Divergence Trading.

Did You Know? (Useful Facts About Divergence Trading)

Alright! Now is the time to find out some interesting and useful facts which are connected with Divergence Trading. These facts are unique to this type of trading, and if followed, can be quite beneficial to you as a trader. We will discuss them one by one. So, Did you know that:

You can Make Your Trade More Profitable With a Particular Order Type?

There are some “Order Types” of Divergence Trading, and each has its own importance. There are four Order Types in total, and here we will take a look at them and also a particular Order Type can be more profitable than the other in a particular situation. The Order Types are:

Market Order

This Order Type is the basic one which gets executed when you enter the market and do not specify the price of the same. But, this can be bad for you since it means you will buy the share at the current offer price (selling price, for instance, $11) even if it is higher than the bid price (buying price, for instance, $10.50).

Limit Order

In this case, a limit price is set for you to buy a stock. For instance, if you enter the market with the Limit Order of $10.50, your order will not be executed before the offer price is $10.50.

Stop Loss Order

With this type, you can set a limit on the amount of funds you wish to trade. For instance, if you wish to trade only $500 on a trade, then you can set your Stop Loss (for selling the shares) at 40 cents and once the price reaches $499.40 cents, it will turn into a Market Order. This will, conclusively, limit our losses.

Stop Limit Order

This is similar to Stop Loss Order but is applicable to buying of shares. For instance, if you wish to buy the share at $1.10 and not more than that, then you can set it as your trigger price. Once the share price reaches $1.10, your limit order will be triggered.

Now, the main point here is that, if you are aware of all these Order Types, then in a particular given situation of buying or selling, you will be able to pick one of the above options to place your order.

For instance, A Limit Order is more profitable than the Market Order. But, only in case you do not care about the speed or time, it may take for your preferred price to be triggered. And, in case you want to sell at a certain price, Stop Loss will help you do so. Whereas, in case you wish to buy at a particular price, then Stop Limit is more beneficial to avoid losses. Hence, either to help you get more profits or to evade losses, knowing the order types is essential.

Connecting the Right Points is of Utmost Importance?

You must give importance to the fact that connecting the right points on the graph depicting Highs and Lows of the actual price is of utmost importance. There will be four things here - a previous high, a current high, a previous low and a current low.

It is really important that you connect only the previous with the current (High or Low) as shown in the image below.

Another important thing to do is to connect all the previous Highs (Higher Highs or Lower Highs) and previous Lows (Higher Lows and Lower Lows) in the actual market as well as the Indicator as is shown in the image below.

Another important point is that you must not forget to connect the verticals, which means that the points as in the Actual Market Price (High or Low) should be connected in the Indicator. Take a look at the image below.

Longer Time Frames are More Relevant than the Shorter Ones?

It has been rightly observed that the Longer Time Frames are more accurate than the Shorter ones since you get less false signals in them. This definitely means that there would be fewer trades, but there are more accurate signals, and if you plan the trades well, you can gain much more in such a scenario. Shorter ones, on the other hand, are less reliable. For instance, one-hour charts or even longer than that can play the trick for you.

Entering the Market Too Early Can Lead To Losses?

It has been also seen that entering the market too early can lead to losses. And, in case you enter the market too early too often, it can lead to huge losses. But, you are making use of Divergence Trading to make profits and not losses. In this scenario, you must remember these points:

You must wait for the Indicator crossover since it indicates a potential shift in the momentum. This implies that there can be a shift from buying toward selling or from selling toward buying after the crossover happens. This is shown in the image below.

Source: babypips

Secondly, you must wait for Indicator to be out of oversold or overbought category since if it stays in one of them for a long period of time, it may not be able to indicate a reversal accurately. Refer to the image below for understanding the same.

Source: babypips

Okay Now! Let us move ahead to find out How to Use Regular and Hidden Divergences.

How to Use Regular and Hidden Divergences?

As we read about the Types and Oscillators of Divergences above, we understood the importance of each correctly. But, now what remains is to know how to use them in trading?

Basically, Divergence helps the trader recognize a potential change in market price and also, helps to make appropriate trading decisions on the basis of the same.

Let us find out how you can use Regular and Hidden Divergences (alongwith their Oscillators) in making the trading decision.

Regular Divergence

As we saw earlier, a Regular Divergence plays quite an important role in finding out when a trend reversal is expected to occur. Seeing Convergence-Divergence with MACD oscillator, we know that Convergence means trend is likely to continue and Divergence means trend reversal is more likely to occur.

Regular Bullish Divergence is noted when the actual price in the market makes Lower Lows but the Indicator makes Higher Lows (uptrend).

Regular Bearish Divergence is noted when the actual price in the market makes Higher Highs but the Indicator makes Lower Highs (downtrend).

In both the cases, we expect a trend reversal.

Now, Regular Divergence can be used to make the following observations:

  • Divergence means that the trend reversal is expected.
  • In case the currency shows double or triple divergence, a trend reversal has a decent probability. Hence, the likelihood of trend continuation (Convergence) is unlikely to happen.

In Regular Divergence, the oscillators indicate the momentum shift and thus, point toward a reversal of the trend. This implies that observing the Divergence helps to know that the end of a trend is expected. But, we have already mentioned but would again emphasize on making use of other factors as well to confirm if the trend reversal or ending of the trend is actually going to happen.

It is not advisable to carry out with a conclusion only on the basis of Divergence. And, moreover, it is always beneficial to get an extra confirmation about a potential ending of a trend.

Hidden Divergence

Hidden Divergence, on the other hand, is a brilliant Indicator of trend continuation (Convergence).

Hidden Bullish Divergence occurs when the actual price in the market is making a Higher Low but the oscillator is making a Lower Low (uptrend).

Hidden Bearish Divergence occurs when the actual price in the market is making a Lower High but the oscillator is making a Higher High (downtrend).

You can see both Regular Divergence and Hidden Divergences in the graph below.

Source: Trading strategy guides

In the graph above, you can see that a Regular Divergence makes for a reversal in the trend and thus, the price moves down +-/-350 pips.

Also, it is visible that a Hidden Divergence makes for a continuation in the trend, which makes the price go up 400 pips and it goes on.

Conclusion

As the article aimed to discuss the importance of Divergence in Trading and also how an experience in the same can help gain profits, we have put the emphasis on its meaning and uses. Apart from the basics, we covered some significant aspects where the “Facts” of the same revealed how you can make Divergence more profitable in each situation. With a brief overview of everything important, this article covered what makes Divergence profitable for you as a trader. Hence, an Experience in Divergence is a must since it can get profits with the applications put at the right places. Hope the article helped you gain a useful insight into Divergence Trading!

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