Last Updated on 3 November, 2022 by Samuelsson
Whether you’re a stock or Forex trader, divergence is one of those signals your technical indicators will likely produce most times, but it requires great skill to know how to spot it. And now, you may be wondering what divergence means in trading.
In trading, divergence means is a signal produced by momentum indicators or oscillators, which shows that the price and the indicator are no longer in phase. It is either the price is making a higher high when the indicator is making a lower high or vice versa. The implication is that the price is losing momentum and is likely to reverse soon.
To help you understand divergence and how to use it, we will discuss the topic under the following headings:
- What is divergence in the stock market?
- Types of divergence in trading
- What Indicators are used in divergence trading?
- How do you trade divergence?
- How accurate is divergence trading?
- What’s the best timeframe to trade divergence?
- Other ways you can use divergence in trading
- Tips on how to use divergence in trading
What is divergence in the stock market?
To understand what divergence means in trading, you need to ask yourself the question: “What does divergence mean?” The term “divergence” describes a situation when two factors that used to be in phase become out of phase. For example, if price increment is associated with an increase in volume, when there is a price increase with a decrease in volume, you can say there is a divergence between price and volume data.
In the stock market, divergence occurs when a stock’s price and a momentum indicator (or oscillator), such as the MACD or stochastic, are not in phase as they used to. It could be that the price is making a higher low while the indicator is making a lower low. There are three other ways divergence can occur, but the key thing is that the price swings and indicator swings are not in phase. Divergence signals a potential decline in price momentum, which may result in the price changing direction in most cases.
Types of divergence in trading
Divergence can be classified in two ways:
- Based on the type of price swing that forms it:
- Regular (classical) divergence: This type is formed when the price swing is making a lower swing low or a higher swing high.
- Hidden divergence: This type is formed when the price is making a higher swing low or a lower swing high.
- Based on the type of signal it gives:
- Bullish divergence: This is a divergence that gives a bullish reversal signal.
- Bearish divergence: As the name implies, it is a divergence that gives a bearish reversal signal.
Integrating the two categories of divergence, we arrive at four types of divergence, as follows:
- Regular bullish divergence
- Regular bearish divergence
- Hidden bullish divergence
- Hidden bearish divergence
Regular bullish divergence
This type of divergence occurs when the price swing is making a lower low while the oscillator is making a higher low. It mostly forms after a prolonged downtrend or a multi-legged pullback in an uptrend, and it is a bullish reversal signal
Regular bearish divergence
This type of divergence occurs when the price is making a higher swing high while the indicator is making a lower high. It occurs mostly when the price has been in an uptrend for a long time, and it gives a bearish reversal signal.
Hidden bullish divergence
A hidden divergence occurs when the price is making a higher swing low while the oscillator is making a lower low. It is seen mostly when there is a pullback in an uptrend, and it gives a bullish signal, marking the likely end of the pullback and a continuation of the uptrend.
Hidden bearish divergence
This type of hidden divergence occurs when the price is making a lower high while the oscillator is making a higher high. It is seen mostly when there is a pullback (a price rally) in a downtrend; it gives a bearish signal, marking the potential end of the pullback and a continuation of the downtrend.
What Indicators are used in divergence trading?
There are many indicators out there that can help you spot a divergence, but in this article, we will focus on these four indicators.
- MACD (Moving Average Convergence/Divergence): The MACD is a momentum indicator that is created with two moving averages. It shows the relationship between a 9-period moving average of the difference between two moving averages (26-period and 12-period) and the difference between the two moving averages. It can be depicted as two lines or a line and a histogram. Because they swing about a zero level, the indicator can show divergence signals.
- RSI (Relative Strength Index): The RSI measures the magnitude of the recent price difference to evaluate overbought or oversold levels in the price chart. It oscillates between 0 and 100 and can show divergence signals
- Stochastic: Stochastic is a momentum indicator that shows the ratio of the current close price to the highest or lowest price stated in a set period. The indicator oscillates between 0 and 100 and shows divergence signals.
- CCI (commodity channel index): The Commodity Channel Index (CCI) is a technical indicator that measures the difference between the current price and the historical average price. It is a momentum-based oscillator used to help determine when a stock price is reaching a condition of being overbought or oversold. The indicator oscillates about the zero level and can give divergence signals.
How do you trade divergence?
Technical traders generally use divergence signals to enter a position when the price swing does not correspond with the oscillator momentum. The key factor to spotting a divergence is to identify when the price is making a new swing high or low and check whether the indicator is making a corresponding swing.
To get it right and enter a trade at the right time, here are steps to take:
- Identify the current direction of the trend in the stock’s price chart and draw the trend line.
- Compare the current price swing high or low with the one preceding it to know which is higher or lower.
- Attach your preferred oscillating indicator to the chart and identify the relevant peaks/troughs on the indicator that match the swing highs/lows on the price Check chart.
- Check whether there is a divergence between the current price swing high/low and the indicator’s current peak/trough.
- Define the signal direction and determine your entry point, which can be at the open of the next candlestick after the divergence is formed.
- Be sure that the price is bouncing off a strong support or resistance level.
- Place your stop loss order some distance beyond that support or resistance level.
- Choose an appropriate profit target or use a trailing stop strategy to secure your profits.
What’s the best timeframe to trade divergence?
There is no best timeframe for trading divergence, but generally, in shorter timeframes, divergence signals occur more frequently and are less reliable. On the other hand, in higher timeframes, divergence signals occur less frequently but are more reliable — the higher the timeframe the more valid and stronger the signal.
The key problem with using shorter timeframes is the noise, which causes many false signals. You can reduce your chances of getting whipsawed too often by only trading divergence that occurs on the daily timeframe. It is even better if you have a multi-timeframe divergence. The likelihood of a reversal increases when more timeframes show divergence between price and momentum.
How accurate is divergence trading
As we stated earlier, the accuracy of divergence trading depends on the timeframe you are trading. the higher the timeframe, the more reliable the divergence signal. But even on the higher timeframes, divergence trading is not accurate, as it fails more times than it succeeds. The major problem with divergence trading is that sometimes it indicates a potential reversal that never plays out. Some other times, the price swing will continue moving until the diverging indicator catches up and becomes in phase with it.
It is possible to profit from trading divergence when you understand the basic concept of divergence and also back-test your strategy. But please note that you should not rely on divergence alone to enter your trades. Only do so with other confirmation indicators.
Other ways you can use divergence in trading
Another way to use divergence in trading is to anticipate a potential price reversal and close your existing position. That is, you can use a divergence signal to get out of a trend-following position because it shows when the price is likely to reverse. However, this can only be an emergency exit — you notice it and decide to get out of your position. It cannot be your main exit strategy as divergence doesn’t occur all the time. You must have a profit target or trail your profit with a stop trailing strategy.
Tips on how to use divergence in trading
Here are some tips that can help you to make good use of divergence in trading:
- Consider the price scenario: One thing you must know is that for a divergence to exist, the price must form one of the following: a lower swing low, a higher swing high, a higher swing low, or a lower swing high. The corresponding indicator swing, on the other hand, must be out of sync with that of the price. Divergence can not be confirmed if none of the above scenarios in the price plays out.
- Keep your eyes on the trend: It is important you draw trend lines. This can help you to easily see the trend and how the price swings relate to each other. When you draw a trend line on your price chart, you easily see whether the price is making a higher low or a lower high, and if you add a channel, you can see the higher high or lower low scenarios easily. But when it comes to analyzing, you have to look at your indicator and compare what you see to the price action in the chart. You can connect the indicator peaks/troughs to be sure of a slope.
- Wait for the indicator to turn: Irrespective of whatever indicator you’re using to spot divergence, it is important to wait for the indicator to turn in the direction of the signal. For a bullish signal, the indicator must turn upward, and for a bearish signal, the indicator must turn downward. Unless there is a reversal candlestick pattern bouncing off a key support or resistance level, make sure you wait for the indicator to turn before placing a trade.
- Don’t chase it: It is very important to note that some divergence signals would require you to trade against the trend. While a divergence signals a decrease in momentum, it may not necessarily lead to a price reversal. It is also important to know that missing an opportunity doesn’t mean there won’t be more, so don’t chase after it; wait for another opportunity to present itself.
- Take extra care: Divergence signals are more accurate when seen on higher timeframes compared to the shorter timeframes, so look for it on a higher timeframe. It is even better if find divergence in multiple timeframes at the same time. Shorter timeframes will present a lot of signals which might result in getting you whipsawed often. To trade successfully, trade them only when there is a corresponding divergence or a major supporting factor, such as the trend or a chart pattern, on the higher timeframe.
- Pay attention to volume: Often, traders tend to ignore one obvious thing on the chart — the volume. You can use the volume to confirm a divergence signal. The volume will typically tell you the level of activity in the market at that moment, so it can confirm a decline in price momentum. Hence, if the volume is low when you spot the divergence, it could be a positive signal for your trade, but always seek more confirmation to ensure you don’t enter a wrong trade.