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A Practical Guide to Screening for and Trading Bullish Divergences
Most traders are familiar with oscillators, such as the relative strength index (RSI) or moving average convergence-divergence (MACD), but they may not realize that there’s more to them than waiting for them to reach the extremes.
It’s true that the RSI or MACD can alert you to overbought or oversold conditions, but the real insights come when comparing their trend to the overall price trend. These comparisons can uncover subtle changes in momentum, known as divergences, that often precede a larger trend change.
Let’s take a look at how to screen for and trade bullish divergences and boost your trading performance.
What is a Bullish Divergence?
A bullish divergence is a bullish trading signal that occurs when prices moves lower and an oscillator — a type of technical indicator measuring momentum — moves higher.
The upswing in momentum signals that there could be a change in the underlying trend, but the still-falling price means that the market hasn’t caught on yet. This creates an opportunity for traders to take a long position or exit a short position ahead of the upcoming trend change.
There are three types of bullish divergences:
- Class A divergences occur when prices are reaching new lows, but oscillators are reaching higher lows than they did during their previous decline.
- Class B divergences occur when prices experience a double bottom and an oscillator reaches a higher low than it reached during its previous decline.
- Class C divergences occur when prices reach new lows while an oscillator reaches the same bottom, making it weaker than Class A or Class B divergences.
You can look for bullish divergences across many different oscillators, such as:
- Relative Strength Index (RSI)
- Moving Average Convergence-Divergence (MACD)
- Rate of Change (ROC)
- Stochastics
- Commodity Channel Index (CCI)
- Advance-Decline Line (AD)
- On-Balance Volume (OBV)
- Chaikin Money Flow
The best opportunities are simple: The price should be making fresh lows and the oscillator should be starting to recover from its lows with a move higher.
How to Screen for Opportunities
Many traders look for bullish divergences by manually scanning charts, which can be effective but time-consuming. After finding an opportunity, they must continue monitoring the chart for confirmation of a breakout. This makes it easy to miss an opportunity if you’re watching too many charts at once.
TrendSpider makes it easy to set up alerts for bullish divergences across many different charts. When the alert criteria are met, you will receive a real-time email or SMS alert. This lets you focus on many different opportunities at the same time to maximize what you see and minimize the need to look at the same chart for hours on end.
Here’s how to setup a bullish divergence alert:
- Click on the Create Alert button and select Create Multi-Factor Alert.
- Add a parameter for price where the closing price decreased over the period.
- Add a parameter for the oscillator where the oscillator increased over the period.
- Click Create Alert.
You can create more complex bullish divergence alerts by including multiple price points or oscillator movements. In addition, you can create a second alert to watch for confirmation of a breakout, such as a trend line breakout. This can be done with a single click in TrendSpider!
Trading a Bullish Divergence
Bullish divergences tell you that a price trend could reverse, but not when the actual reversal will occur. As mentioned above, it’s a good idea to look for confirmation before making a trade based on a bullish divergence.
There are two key things to look for in the chart:
- Extreme Values: Oscillators that reach extreme ends of the spectrum could mean a nearer-term reversal. For example, a bullish divergence that occurs when the relative strength index is well below 30 could suggest that there will be a reversal sooner rather than later.
- Confirmation: Traders may look for confirmation of a trend reversal using other technical indicators, candlestick patterns or other chart patterns. For instance, a bullish divergence could predict a reversal, but a breakdown from an ascending triangle could confirm the move.
Since bullish divergences involve trading against a prevailing downtrend, it’s a good idea to use stop-loss orders to limit downside risk, particularly if you’re juggling many positions.
Most stop-loss orders placed using other forms of technical analysis. For instance, short-term traders may use a set percentage stop-loss whereas swing or position traders may look at longer-term trend lines or Fibonacci levels.
The Bottom Line
Bullish divergences can be a strong indicator of an upcoming reversal in the trend. By keeping the tips above in mind, you can increase your odds of accurately identifying a divergence and executing a trade at an opportune time.
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