Divergence is a useful tool for a trader to foresee market behaviour and it can be used as a leading indicator because it provides a signal of a trend reversal in advance. So, we must know the concept before reading about these indicators. Divergence is mostly used by traders in trading when stock price follows the opposite direction of movement w.r.t. the technical indications. It should not be relied upon blindly because it is not happening for all price movements and also it does not give signals timely. Momentum indicators are also useful for a trader because they help the trader to analyse the market and pinpoint the spot where the direction of movement or trend can be reversed.
What is Divergence in Trading?
It is a condition when the price of a stock is moving opposite to that of the indication of a technical indicator in that time frame. It is very useful for a trader because it alerts the trader about the weakening of the strength of price movement and can also be a signal of a trend reversal in the near future. It can be found between any technical indicator movement and the price movement of the stock.
Types of Divergence
It is of two types namely positive and negative divergence. The name depicts the future movement of the price of a stock.
Bullish or Positive Divergence
It indicates that a trend reversal can be there and the price will follow an uptrend i.e. price will start rising soon. Since it gives an indication for a future up trend that means presently stock price is following a downtrend and falling while the technical indicators are showing a Bullish phase in that time frame. It occurs when the price of the stock is making lower lows but an oscillator or indicator is indicating higher lows. It usually happens when a downtrend is approaching an end.
Bearish or Negative Divergence
It indicates that a trend reversal can be there and the price will follow a downtrend i.e. price will start falling soon. Since it gives an indication for a future downtrend that means presently stock price is following an uptrend and rising while the technical indicators are showing a Bearish phase in that time frame. It occurs when the price of the stock is making Higher Highs (HH) but an oscillator or indicator is indicating Lower Highs (LH). It usually happens when an uptrend is approaching an end.
Hidden Positive Divergence
Hidden Positive divergence occurs when the price of the stock is making Higher lows (HL) but the indicator or oscillator is indicating lower lows (LL). This generally occurs in the uptrend and it gives a signal of a possible continuation of the uptrend.
Hidden Negative Divergence
Hidden Negative divergence occurs when the price of the stock is making Lower Highs (LH) but the indicator or oscillator is indicating Higher Highs (HH). This generally occurs in the downtrend and it gives a signal of a possible continuation of the downtrend.
Importance of Divergence for a Trader
It is used by traders in their technical analysis but it is used with other indicators because it provides a late alert to traders. It can indicate a major trend change i.e from Bullish to Bearish or opposite in near future. Traders use the divergence to read the hidden strength of the price movement and can forecast the likely happening of a trend change.
For example, a trader can take an oscillator tool like RSI (Relative Strength Index) with the price chart of a stock. If the stock price is rising then RSI should also be showing a high signal ideally. But if the stock price is rising but RSI is showing a negative signal, it means if it shows decreasing value over its chart that means the strength of the price movement is weakening. It can be an indication of the start of the Bearish phase next. So, you as a trader can plan your exit from the trade by booking your profit.
How to trade with Divergence
Many traders took divergence as an opportunity to enter into a trade as it can be used as a leading indicator. But before entering into the trade, you must spot its occurrence on the charts and can go for confirmation as well. And before making a trading decision make sure of the following things and it can act as a checklist for you:
- Price is making Higher Highs than previous High
- Price is making lower lows than the previous low
- Double Top
- Double Bottom
These are the only four conditions when divergence can occur, but you must confirm the occurrence. Secondly, regular divergence shows trend reversal but hidden one shows trend continuation. So, you must confirm before entering into the trade. Finally, if possible try to avoid entry into the trade too early and always wait for confirmation.
Divergence and its Confirmation
Both these terms are different and associated with each other in some ways. Divergence happens when there is a conflict in the direction of actual price movement for a stock and the indication of technical indicators for the price of the same stock in the same time frame. That means a technical indicator is telling that the price is falling while the actual price of a stock is rising.
But, confirmation is the opposite, where the actual price movement and technical indicator both tell the same thing to you as a trader. If the price of the stock is rising in actuality and multiple indicators also indicate the price rise, that means it is a confirmation signal. Traders rely on confirmation more than divergence but it is also useful because it provides them with an alert for a possible trend reversal.
Divergence is used by traders as a leading indicator to ascertain the situation of the stock market with the help of other momentum indicators. But you must be sure enough whether it is real or fake. Because real divergence indicates a trend reversal while fake one signs trend continuation.