Divergences are one of my favourite trading concepts because, when paired with other trading tools and concepts, they provide very accurate high-quality trading signals. What if there was a low-risk way to sell near the top of a trend or buy near the bottom? What if you were already in a long place and knew exactly where to exit without having to see all of your unrealized profits disappear before your eyes because your trade changed direction? What if you think the stock would continue to fall but want to go short at a lower cost or with a less risky entry? There is, nevertheless, a route. It’s known as divergence trading.
Divergence is the calculation of market behaviour concerning an oscillator predictor. It makes no difference what kind of oscillator you use. You may use RSI, Stochastic, MACD, CCI, and other indicators. The best thing about divergences is that they can be used as a leading indicator and are not difficult to detect after some practice. Divergences can be reliably profitable when traded correctly. The best thing about divergences is that because you’re normally buying near the bottom or selling near the top, your risk on trades is very low in comparison to your potential reward.
Consider the terms “higher highs” and “lower lows.” If the price is making highs, the oscillator should be making higher highs as well. If the price is making lower lows, the oscillator should be doing the same. If they are not, it means that the price and the oscillator are diverging. As a result, the word “divergence” was coined.
Divergence can be divided into two types:
- Regular Divergence
- Hidden Divergence
A normal divergence is regarded as a potential predictor of a trend reversal. When the price makes lower lows (LL) but the oscillator makes higher lows (HL), this is referred to as regular bullish divergence. See Figure 1.1 below:
Figure 1.1 - Regular Bullish Divergence
When the price makes a higher high (HH) but the oscillator makes a lower high (LH), you have regular bearish divergence. See Figure 1.2 below:
Figure 1.2 - Regular Bearish Divergence
A hidden divergence is used to forecast the continuation of a pattern.
Hidden bullish divergence happens when the market makes a higher low (HL) but the oscillator makes a lower low (LL). See Figure 1.3 below:
Figure 1.3 - Hidden Bullish Divergence
Hidden Bearish Divergence:
If the price makes a lower high (LH) whereas the oscillator makes a higher high (HH), you have secret bearish divergence. See Figure 1.4 below:
Figure 1.4 - Hidden Bearish Divergence
Here’s how you could profit from divergences:
|Regular||Higher High||Lower High||Short|
|Regular||Lower Low||Higher Low||Buy|
|Hidden||Higher Low||Lower Low||Buy|
|Hidden||Lower High||Higher High||Short|