What Is Divergence in Technical Analysis?
In this article, we will explore what divergence is in more detail, the different types of divergence and how to identify them, the pros and cons of incorporating divergence into your trading strategy, and more. Whether you are a seasoned trader or just starting out in the world of financial markets, understanding the concept of divergence can be a valuable tool for making informed trading decisions.
What Is Divergence?
In technical analysis, divergence refers to a situation where the price of an asset and a technical indicator that is used to analyze that asset’s price movement, such as a momentum oscillator or a moving average convergence divergence (MACD) indicator, move in opposite directions.
Divergence is often seen as an important signal for traders and investors, as it may indicate a potential change in the trend of the asset. This is because it suggests that the momentum behind the price movement is weakening or changing direction, which could be a sign that the previous trend is losing steam and a reversal may be imminent.
Types of Divergence
There are two main types of divergence that can occur in technical analysis: bullish and bearish divergence.
- Bullish Divergence: Bullish divergence occurs when the price of an asset is making a lower low, but the technical indicator is making a higher low. This suggests that the momentum behind the downtrend is weakening, and the price may be about to reverse and start an uptrend. Bullish divergence is typically seen as a buy signal by traders and investors.
- Bearish Divergence: Bearish divergence occurs when the price of an asset is making a higher high, but the technical indicator is making a lower high. This suggests that the momentum behind the uptrend is weakening, and the price may be about to reverse and start a downtrend. Bearish divergence is typically seen as a sell signal by traders and investors.
How to Identify Divergence
Here are the steps to identify divergence:
- Choose a technical indicator: Select a technical indicator that you want to use to identify divergence.
- Look for price and indicator movements: Observe the price movements of the asset and the movements of the technical indicator. Look for situations where the price is moving in one direction while the indicator is moving in the opposite direction.
- Compare highs and lows: Identify the highs and lows of both the price and the indicator. In bullish divergence, the price makes a lower low, but the indicator makes a higher low. In bearish divergence, the price makes a higher high, but the indicator makes a lower high.
- Confirm the signal: Once you have identified potential divergence, confirm the signal with other technical analysis tools. Look for other indicators or chart patterns that support the potential reversal signal.
- Make trading decisions: Based on your analysis, make a decision to buy, sell, or hold the asset. Keep in mind that divergence is just one tool in technical analysis, and it should not be relied on exclusively for making trading decisions.
Common Technical Indicators to Identify Divergence
- Relative Strength Index (RSI): This is a momentum indicator that measures the speed and change of price movements. It is commonly used to identify overbought or oversold conditions and potential trend reversals.
- Moving Average Convergence Divergence (MACD): This is a trend-following momentum indicator that shows the relationship between two moving averages of an asset’s price. It is commonly used to identify trend direction and potential trend reversals.
- Stochastic Oscillator: This is a momentum indicator that compares a security’s closing price to its price range over a certain period of time. It is commonly used to identify overbought or oversold conditions and potential trend reversals.
- Relative Vigor Index (RVI): This is a technical indicator that measures the strength of a trend and its direction. It is commonly used to identify potential trend reversals and confirm trend direction.
When comparing indicators to use when identifying divergence, it’s important to consider the strengths and weaknesses of each indicator, as well as how they complement each other. Traders should also consider the asset being traded and the timeframe being used, as certain indicators may be more effective for specific assets or timeframes.
Pros and Cons of Divergence in Trading
Like any technical analysis tool, divergence has its advantages and disadvantages. Here are some of the pros and cons of using divergence in trading:
- Early indication of trend reversal: Divergence can provide an early indication of a potential trend reversal, allowing traders to enter or exit positions before the trend actually changes direction.
- Objective measure of momentum: Divergence is an objective measure of momentum that can be used to confirm or refute price trends.
- Easy to use: Divergence can be easily identified using popular technical indicators, such as the RSI and MACD, making it accessible to traders with varying levels of experience.
- Can be used in conjunction with other indicators: Divergence can be used in conjunction with other technical analysis tools, such as support and resistance levels, to further confirm trading signals.
- Subjectivity: Identifying divergence requires subjective interpretation, which can lead to different traders interpreting the same data in different ways.
- False signals: Divergence can produce false signals, especially in volatile markets, leading traders to enter or exit positions prematurely.
- Lagging indicator: While divergence can provide an early indication of a potential trend reversal, it is still a lagging indicator, meaning that it may not accurately predict the exact timing of the trend reversal.
- Limited use: Divergence is best used in certain market conditions, such as trending markets, and may not be effective in other market conditions, such as sideways markets.
Divergence can be a useful tool in a trader’s toolbox, but it is important to use it in conjunction with other technical analysis tools and to be aware of its limitations.
Divergence vs. Hidden Divergence
Divergence and hidden divergence are both technical analysis concepts that involve comparing the price of an asset to a technical indicator to identify potential trend reversals. While they may sound similar, they have different meanings and implications:
- Divergence occurs when the price of an asset is moving in one direction while a technical indicator is moving in the opposite direction. This can suggest that the trend is weakening and that a trend reversal may be imminent.
- Hidden divergence, on the other hand, occurs when the price of an asset is making a higher high or lower low, but a technical indicator is making a lower high or higher low. This can suggest that the trend is continuing and that the current direction may persist.
While both divergence and hidden divergence can be useful indicators of potential trend reversals or continuations, they have different implications for traders. Divergence may suggest that it’s time to consider taking profits or reversing a position, while hidden divergence may suggest that it’s a good time to hold onto a position or consider adding to it.
The Bottom Line
In conclusion, divergence is a popular tool among technical traders that can provide an early indication of potential trend reversals. By comparing the price of an asset to a technical indicator that measures momentum or trend strength, traders can identify situations where the price and indicator are moving in opposite directions, which may suggest that the trend is weakening.
Like any technical analysis tool, divergence should be used as part of a comprehensive trading strategy, and traders should always practice proper risk management and use other indicators to confirm trading signals. With experience and practice, traders can learn to effectively use divergence to identify potential trend reversals and make informed trading decisions.