analysis, divergence occurs when a momentum indicator, like some oscillators,
starts to go the opposite direction compared to the price action. This
phenomenon shows a weakening in price momentum and signals possible pullbacks
or even change in trends. The most used indicators for divergence trading are
the RSI and the MACD.
four types of divergence: bullish (positive), bearish (negative), hidden
bullish (positive) and hidden bearish (negative). The bullish (positive)
divergence occurs when the price makes a new low, but the oscillator makes a
high compared to the previous data. On the other hand, a bearish (negative)
divergence occurs when the price makes a new high, but the oscillator makes a
low compared to the previous data. These two types of divergence are also
Divergence using the
(positive) hidden divergence happens when in uptrend the price makes a higher
low, but the oscillator makes a lower low. On the other hand, a bearish
(negative) hidden divergence happens when in a downtrend the price makes a
lower high, but the oscillator makes a higher high. The hidden divergence can
signal a continuation of the trend.
Divergence using the
previously mentioned, regular divergence signals a weakening momentum, and the
price can either pullback or change completely the trend. There are different
targets where the price can go to once a divergence works out. The first target
is generally the previous swing point or a trendline and instead of taking a
risky counter-trend trade you can use this opportunity to wait for the price to
pullback to the swing point or the trendline and then trade a continuation of
the original trend. Below you can see some examples where divergent price
action pullbacks to trendlines and swing point before continuing the upside
Divergent price action
target of the regular divergence is the last swing point that technically
defines a trend. Once the price breaks out of that swing point, the trend is
said to be changed on that specific timeframe. Below you can see an example
where the price pullbacks all the way up to that last swing point and then gets
rejected almost perfectly before continuing the original downtrend. Again,
instead of trying to catch the point when the price starts to go all the way up
to the swing point, you can wait for it to complete the run and then entering
in anticipation of the continuation of the trend to catch bigger moves and to
limit better risk.
Last swing point as
usual target of the regular divergence can be the last swing point that began
an entire divergent move. This generally happens with a chart pattern called
wedge, which is divergent in nature.
goes up/down slowly with pullbacks getting smaller and smaller and the
oscillator signalling a weakening momentum for the entire move which at some
point just breaks out and goes all the way back to the swing point when the
divergence started to occur. Below you can see an example of a wedge type
divergence and the price pulling all the way back to the swing point when the
divergence began. Curious fact is that before continuing the upside trend,
there was another divergence that could confirm that level as a possible
support for a continuation trade.
To sum up,
divergence is a nice and handy technical analysis concept which can help in
risk management and even timing. As you saw from previous examples, it’s not
used on its own but complemented with other technical concepts like swing levels,
trendlines and so on to give more structure.
was written by Giuseppe Dellamotta.
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