There are a few technical indicators, also known as oscillators which are used when a chart doesn’t show a direction of movement or a trend. Thus when oscillators are used, ideally when prices goes to a new high, oscillators should also move towards the high and so on. Divergence is a situation which arises when there is a discrepancy between the oscillator and the price. So when do you see divergence? Just to re-iterate divergence will be seen when you compare price to movement of the oscillator or the indicator. Important thing about divergence is that it is a trading strategy. Let’s see how.
Always remember that when using oscillators, the price and oscillators should move together. If the price makes higher highs, oscillators should also make higher highs and similarly if the price makes lowers lows, oscillators should also make lower lows. When they diverge from each other we have the divergence as already mentioned. Forex traders utilize indicators such as Relative Strength Index (RSI), moving average convergence divergence (MACD) or Stochastic index for measuring the momentum. These are also known as divergence indicators.
Divergence is classifies into two main types.
A regular divergence is a sign of trend reversal. When price makes lower lows and oscillator makes higher lows, the divergence can be referred to as a regular bullish divergence. This normally occurs by the end of a downtrend. Similarly, when price makes higher highs and oscillator tends to make lower highs, it is known as Bearish Regular divergence. This normally occurs by the end of an uptrend.
In both the cases oscillators indicate that even though price has made higher highs (Bearish) or lower lows (Bullish), it won’t continue the trend and chances are that of a trend reversal. Hence, for a bearish divergence, uptrend reverses to downtrend and it is a sell signal. For a Bullish one, downtrend is going to reverse to an uptrend and ideally it is good to buy.
While regular divergences signal trend reversal, hidden divergences signal trend continuation. Hidden Bullish Divergence occurs when price is making higher lows and oscillator is making a lower low. This is normally seen in an uptrend and prices are expected to go high. So this signals a buy.
Hidden Bearish divergence occurs when price makes a lower high, while oscillator shows a higher high. This happens during a downtrend and the expectation is that downtrend will continue and prices would go down. So the signal is to sell.
Here is a summary of both types of divergences.
Never be in a hurry to place the trade thinking that a divergence has occurred and it indicates a continuation of an uptrend or a downtrend. Always wait for a confirmation using trend lines or other tools to ensure a continuation or reversal is going to happen.
Divergences are indicators and are not 100% correct. But as we always say, when used in combination with other indicators and tools you could be more confirmed ad at low risk. Keep watching your charts to spot the divergences and keep trading.