One of the most powerful tools for a trader is Divergence. You cannot start your trading journey without knowing how to spot and use divergence indicator. But first of all, you must understand it.
Divergence is spotted by comparing price action to an indicator. It can be the RSI, MACD, Stochastic or any other suitable indicator (usually oscillators). Price and indicators usually move together – price goes up and the same is seen in the indicator; price comes down, the indicator comes down. But sometimes, the indicator doesn’t match the movement of price. Price makes a higher high, but the indicator fails to rise to new highs; instead it just forms a lower high. This is Divergence and a sign that price will possibly come down.
Divergence is identified by comparing two Highs or Lows of price with the corresponding ones on the divergence indicator. There are two types of divergence: regular and hidden. Next we are going to talk about both of them:
- Regular bullish divergence forms when price makes Lower Lows, but the indicator makes Higher Lows. This signals a possible bottom and a trend reversal.
- Regular bearish divergence forms when price makes Higher Highs, but the indicator makes Lower Highs. This signals a possible top and a trend reversal.
- Hidden bullish divergence forms when price makes Higher Lows, but the indicator makes Lower Lows. This is indicative of a possible trend continuation.
- Hidden bearish divergence forms when price makes Lower Highs, but the indicator makes Higher Highs. This is indicative of a possible trend continuation.
Try to spot divergences on the charts using the classification from above. It will be hard in the beginning, but you will get used to it eventually and you will see that Divergence can be a great help.
No matter how good an divergence indicator, a pattern or any trading tool is, don’t use it by itself and try to confirm your signals with some other type of analysis. You can do this by using confluence. Confluence forms in a spot where you have more than one indication of where price will go. For example, confluence occurs where price reaches a confirmed horizontal level of support or resistance and a confirmed trend line. This is a two point confluence. If in that point, you see divergence forming, confirming your direction, you will have a stronger signal and a higher probability of price going your way. Here is an example:
When price touched the trend line, it also touched the resistance level. Add to that the hidden bearish divergence on the RSI and the fact that the RSI is almost reaching overbought territory and you have a good short trade. You must understand that these are just examples and that price sometimes doesn’t go your way no matter how much confluence you have when you enter the trade.
It never hurts to have extra confirmation when you enter a trade and you should always make decisions based on several factors.