Profiting From Divergence: An Advanced Trading Strategy – One of the basic principles of technical analysis is that momentum precedes price. However, prices never move in a smooth line and momentum will often be out of sync with price. This mismatch between momentum and actual price is referred to as a divergence. Traders can exploit these price differences for profit.
The Divergence Cheat Sheet below provides an easily accessible, in-depth look at what a divergence is, the different types of divergences, and how to trade divergence effectively.
Profiting From Divergence: An Advanced Trading Strategy
In trading, divergences occur when the price of an asset and the indicator move in opposite directions. In other words, when the price of an asset is out of sync with the corresponding indicator’s readings, a divergence signal occurs.
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Under normal market conditions, the price action of an asset and the technical indicator move in the same direction. In other words, when the price prints a new high, the technical indicator should also print a new high.
Divergence is not a technical indicator per se, but a trading concept. There is no mathematical formula for calculating divergence.
The main purpose of a divergence is to signal momentum building into a trend and provide early reversal signals when there is a slowdown in momentum.
Divergence does not indicate when the reversal will occur, but it is an early warning sign that price may soon reverse.
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To really dig deeper into the market, traders need to understand the fundamentals of how price moves in any market.
At its core, asset prices move in a series of higher highs and higher lows when we develop an uptrend. Conversely, when we develop a downtrend, asset prices move in a series of lower lows and lower highs.
The concept of successful trading is to buy low and sell high. In other words, buy when the price makes a new low and sell when the price makes a new high.
Divergences can help traders distinguish when to buy at a new low and sell at a new high. This is done by studying the divergence signals – the mismatch between the price and the technical indicator.
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Regular bullish divergence happens when we have a disagreement between prices that are falling (making lower lows) and a technical indicator that is rising (making higher lows).
Regular bearish divergence happens when we have a disagreement between prices that are rising (making higher highs) and a technical indicator that is falling (making lower highs).
The regular bullish divergence is an early sign that the prevailing downtrend will change direction and turn to the upside. In this regard, the regular bullish divergence is a buy signal.
Conversely, the regular bearish divergence is an early sign that the prevailing uptrend is about to change direction and turn to the downside. In this regard, the regular bearish divergence is a sell signal.
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The ideal place for a regular bullish divergence to develop is at the end of a downtrend. This type of divergence then naturally leads to an uptrend.
Conversely, the ideal place for a regular bearish divergence to develop is at the end of an uptrend. This type of divergence then naturally leads to a downward trend.
The hidden divergence is not that different from the ordinary divergence. In order for a hidden divergence to occur, we need to see a mismatch between the price and the technical indicator corresponding to ordinary divergence.
However, while regular divergence signals a possible trend reversal, the hidden divergence signals the possibility of trend continuation. Hidden divergences tend to develop within an existing trend.
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A hidden bullish divergence occurs when the price makes a higher low while the indicator simultaneously makes a correspondingly lower low.
The hidden bullish divergence is an early sign that the prevailing uptrend is ready to resume. These divergence signals develop after prices pull back. In this regard, the hidden bullish divergence is a buy signal.
Hidden bearish divergence occurs when the price makes a lower high while the indicator simultaneously makes a correspondingly higher high.
This serves as an early sign that the prevailing downtrend is ready to resume. Typically, a hidden bearish divergence signal develops after prices pull back. In this regard, the hidden bearish divergence is a sell signal.
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Hidden divergences do not occur as often as common divergences. However, hidden divergences can tell traders in advance when a prevailing trend may resume.
In a nutshell, the hidden divergence occurs at the same time as short-term retracements in price. In other words, the hidden divergence signals the potential end of a pullback.
Before recognizing regular divergence and hidden divergence and the possible trend reversal signals or trend continuation signals, traders should choose a technical indicator.
Usually, momentum oscillators like RSI, Stochastic, MACD, etc. are used by retail traders to determine when the price of an asset and the indicator are not converging.
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In the same way that the price of an asset moves up and down and establishes peaks and valleys, technical indicators converge or diverge from the price, producing corresponding peaks and valleys.
Some technical indicators can be applied directly to the price chart or in a separate window, usually below.
In contrast, the money flow index (MFI) is an alternative to identify hidden divergence. This is because the cash flow index is a trend following indicator.
The Relative Strength Index (RSI) indicator is one of the most popular technical indicators for spotting regular divergence and hidden divergence.
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However, the RSI divergences cannot be used as a timing tool. In this case, candlestick chart patterns can act as a confirmation of the resumption of the prevailing trend (in case of RSI hidden divergence) or trend reversal (in case of RSI regular divergence).
Traders can look for long positions if they detect regular or hidden RSI bullish divergence. On the other hand, traders can look for sell positions if they spot regular or hidden RSI bearish divergence.
The price is making a new lower low compared to the previous swing low on the price chart. At the same time, the RSI indicator prints a higher low compared to the previous low.
After forming the highest low on the price chart, the prevailing trend resumes and moves to new highs.
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It is crucial to understand that the bullish hidden divergence can develop anywhere in the uptrend as long as all the technical conditions are met.
Price is making higher highs in a regular bearish RSI divergence, but the RSI oscillator is printing lower highs.
In the example below, traders can see that the price is making a new higher high compared to the previous swing high on the price chart.
At the same time, the RSI indicator prints a lower high compared to the previous high printed on the RSI oscillator. After the RSI bearish divergence, the price started to reverse quickly and a new trend emerged.
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In summary, traders need to know that regular divergence signals a trend reversal, while at the same time the hidden divergence signals a trend continuation.
Trend following traders are better off focusing on identifying hidden divergences as this will help them ride the overall market trend. Because the hidden divergence is a trend continuation signal, out of the two types of divergence, the hidden divergence has a higher success rate.
Last but not least, trade divergence works across all timeframes; however, the higher the timeframe, the more reliable the divergence signal tends to be.
Pip Hunter I hunt pips every day in the charts with price action technical analysis and indicators. My goal is to gain as many pips as possible and help you understand how to use indicators and price action together with success in your own trading. In an uptrend that will set up as a bearish trade, you will see the price move higher, but you will see the indicator make a lower high.
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In an up-down that will set up as a bullish trade, you will see the price make lower lows, but you will see the indicator go higher, low.
The price should be above the upper Bollinger Bands indicator in case of a bearish divergence and similarly the price should be below the lower Bollinger Bands indicator in case of a bullish divergence.
When the bullish divergence is spotted (time frame 5 min), it is a signal to buy a 1 hour call option.
Buy When the red bars on the ATM RSI Histo Triple Stochastih Divergence indicator go back below the dotted black line.
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Similarly, when a bearish divergence is detected (time frame 5 min), it is a signal to buy a put option.
Sell When the blue bars on the ATM RSI Histo Triple Stochastic Divergence indicator go back below the dotted black line.
This trading method based on divergence can also be applied to binary option strategies High / Low, but this trading method is not for beginners. Candlesticks and oscillators can be used independently or in combination to highlight potential short-term trading opportunities. Swing traders specialize in using technical analysis to take advantage of short-term price movements. Successfully trading these swings requires the ability to accurately determine both trend direction and trend strength. This can be done by using chart patterns, oscillators,
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