Although indicators lag slightly – just as price movement does – when it comes to divergences, this lag helps us locate better and more dependable trade entries, as we will see below. Divergences can be employed by reversal traders and trend-following traders to time their exits.
Let us begin with the most important question: what is a divergence, and what does it tell us about price? Numerous people already get this incorrect.
Divergence occurs when an asset's price moves in the opposite direction of a technical indicator, such as an oscillator, or when it moves in the opposite direction of other data. Divergence indicates that the current price trend may be waning and, in some situations, may result in a price direction change.
Divergence occurs on both positive and negative axes. Positive divergence indicates that an increase in the asset's price is possible, and negative divergence indicates that the asset may move lower.
A divergence occurs when the price hits a higher high on the chart, but the indicator being used makes a lower high. When their indicator and price action are out of sync, it indicates that "something" is occurring on their charts that requires their attention but is not immediately apparent when simply glancing at the price charts.
Divergence occurs when an indicator does not "agree" with the price action. While this is a very basic overview, we will now look at more sophisticated divergence principles and how to trade them, and it is critical to lay a solid basis first.
Divergences of Various Types
First of all, a bull is a trader or investor who anticipates an asset's price will continue to rise. Thus, a bullish divergence occurs when the price of an asset falls while one or more indicators begin to imply an impending rising trend.
Divergence can occur in various asset classes, including currencies, stocks, and commodities. The chart below is an excellent illustration of a bullish divergence.
The polar opposite of a bullish divergence is a bearish divergence, which occurs when an asset's price continues to fall even as the indicator begins to increase.
What Does Divergence Tell Traders
Divergence in technical analysis may indicate a positive upward or negative price trend. A positive divergence happens when an asset's price hits a new low while an indicator, such as money flow, begins to climb. On the other hand, a negative divergence occurs when the price hits a new high, but the underlying indicator makes a lower high.
Traders use divergence to determine the underlying momentum of an asset's price and the likelihood of a price reversal. For instance, investors can plot oscillators on a price chart, such as the Relative Strength Index (RSI). If the stock is growing and setting new highs, the RSI should also be setting new highs. If the stock continues to get new highs, but the RSI begins to make lower highs, the price upswing may be waning. This is referred to as negative divergence. The trader can then decide whether to close the position or place a stop loss if the price begins to decrease.
The converse of this is positive divergence. Consider a situation in which the price of a stock is making new lows while the RSI is making higher lows with each swing in the stock price. Investors may assume that the stock price's lower lows are losing their downward momentum and that a trend reversal is imminent.
Divergence is a typical use of various technical indicators, most notably oscillators.
How to Trade Divergence?
Trading divergences is a difficult task, particularly for inexperienced traders. That is because divergences do not signal when to purchase or sell.
Now, we will go through three indicators that you can utilize to trade the setup. Each will have its own set of advantages and disadvantages.
1. Using the MACD Indicator to Trade Divergence
The moving average convergence divergence is composed of two lines constantly in contact with one another and the zero line.
When employing the MACD, the most frequently used trigger is when the fast line passes through the slow line. If the cross is upward, then the signal is bullish. If the fast line crosses below, a bearish signal is generated.
Additionally, the greater the separation between the two lines, the stronger the signal. The MACD will give a bearish signal if the price action increases, while the MACD lines decrease when it comes to price differences. On the other hand, if the price decreases while the MACD continues to trend upward, you have a bullish MACD divergence.
A negative MACD divergence is depicted in this chart. As you can see, the price is creating higher highs towards the beginning of the chart, while the MACD is decreasing, which results in the chart's bearish divergence. As you can see, this indication is indicative of the beginning of a new bearish trend.
2. RSI Indicator for Trading Divergence
The relative strength index is abbreviated as RSI. The indicator is an oscillator since it consists of a line that fluctuates in three distinct places.
The oversold zone is below 30, the overbought zone is above 70, and the neutral zone is between 30 and 70.
When the RSI crosses above 70, a sell signal is generated. In contrast, a buy signal is generated when the line enters the oversold zone below 30.
This chart demonstrates a positive divergence between the RSI and the MACD.
As a result of the price activity, the chart shows lower bottoms. Simultaneously, the RSI establishes higher bottoms in the indicator area. On the chart, this results in a significant bullish divergence. When this discrepancy is resolved, the price begins a strong upward trend.
3. Using the Stochastic Indicator to Trade Divergence
The stochastic oscillator is yet another member of the oscillator family.
As with the RSI, the two stochastic lines oscillate between three locations within a 0-100 range. These are the oversold area between zero and twenty, the overbought area between eighty and one hundred, and the neutral zone between twenty and eighty.
The stochastic oscillator's (SO) primary signals are overbought and oversold conditions. When the lines enter the overbought region between 80 and 100, we receive a sell signal. In contrast, a buy signal is generated when the lines enter the oversold area between 0 and 20.
The pink area denotes the neutral zone, and the white areas at the top and bottom represent the overbought and oversold zones, respectively.
The stochastic divergence tool operates similarly to the other two tools outlined previously. When the direction of price activity and the direction of the SO diverge, the signal occurs.
Above is a chart with the stochastic indicator linked to the bottom. The price movement is accelerating, but stochastic tops are contracting. On the chart, this results in a bearish divergence. As a result of this divergence, the price movement flips and trends downward.
An Illustration of Trading Divergence
Netflix's 10-minute chart from August 16-23, 2016. The illustration depicts how we trade a bearish divergence, and the price action and the MACD indicator combine to create it.
The graphic begins with a price rise, denoted by a bullish green channel. Simultaneously, the MACD indicator is generating lower highs on the chart. As a result, the bearish MACD divergence is confirmed.
We cannot enter a trade simply because the chart shows a bearish divergence. We require confirmation of the reversal, and we await that indication from the price activity.
Suddenly, the price action bursts through the bullish green corridor at its lower level. The break may be observed in the chart's first red circle. We short NFLX using this breakout.
Simultaneously, we put a stop-loss order above the pre-reversal high. On the graphic, the stop is denoted by a red horizontal line.
Netflix rapidly enters a downturn, as seen by the pink downward trend line. The black arrows indicate instances when the price tries to break through the trend line as resistance.
With the opening bell on Aug 23, 2016, the market action abruptly broke the pink bearish trend line. This is a significant price action indicator that the trend may reverse direction. As a result, we close our short position.
After familiarizing yourself with the notion of divergence in stock trading, we will explore a day trading method for profiting from this scenario.
Trade Entry
When traders notice a discrepancy on the chart, they should not jump into the transaction blindly, and they should first wait for confirmation of the divergence indication through price action.
This typically occurs when the price breaks through its trend line, signaling the start of a reversal. Another entry signal is a price break above or below a support or resistance level.
Traders should take advantage of either of these signs to initiate the trade.
Stop Loss
Traders do not want to be caught off guard by an unexpected move against their position, correct? They can accomplish this by utilizing a straightforward stop-loss order.
Stop-loss orders should be placed above/below the top/bottom formed by the reversal.
In principle, if people caught the new trend as it began, the prior swing point should not have been breached.
Profit Target
The first way for determining profit targets is to establish trend lines on the chart, and they should remain in the trade as long as the stock maintains the trend line.
Another technique that individuals might employ is to monitor when a stock begins to make lower highs or higher lows.
This is a sign that traders may witness a new divergence in the opposite direction of their position. As we can see, the objective is not to make a quick buck as it is to enter a trade at the start of a new trend and then ride it to its conclusion.
Constraints of Trading Divergence
As with all forms of technical analysis, investors should utilize a combination of indicators and research methodologies to validate a trend reversal prior to acting only on divergence. Divergence will not be present for every price reversal; hence, other risk management or analysis must be utilized in conjunction with divergence.
Additionally, it does not necessarily indicate that the market will reverse or that a reversal will occur when divergence occurs. If the price does not react as expected, divergence can persist for an extended period of time, and trading only on it may result in substantial losses.
Traders use divergences to identify whether a trend is weakening, which could result in a trend reversal or continuance.
Before we go out and seek probable divergences, here are a few trading principles for divergences.
1. Ascertain the Divergence's Existence
In order to have a divergence, the price must have taken one of the following forms:
Avoid examining an indicator unless one of the following four price possibilities has occurred. Otherwise, you are not trading a divergence.
2. Draw vertical lines on successive tops and bottoms
Now we have got some activity (recent price movement), have a look. We can expect only one of four outcomes: a higher high, a flat high, a lower low, or a flat low.
Draw a line back to the preceding high or low from that high or low. It MUST be on successive significant peaks/troughs.
If there are any minor bumps or dips between the two major highs/lows, disregard them.
3. Only connect the tops and bottoms
If two swing highs are established, the tops are connected. If two lows are created, the bottoms are connected.
4. Focus on the price
Now we have drawn a trend line connecting two tops or two bottoms. Now examine your favorite technical indicator about the price activity.
Bear in mind that you should compare the TOPS or BOTTOMS of the indicator. Ignore indicators like MACD or Stochastic that have numerous lines stacked on top of one another.
5. Maintain Vertical Alignment of Price and Indicator Swings
The indicator's highs and lows must coincide with the price highs and lows.
6. Keep an Eye on the Slopes
Divergence happens only when the slope of the line connecting the indicator's tops and bottoms is greater than the slope of the line connecting the price tops and bottoms.
The slope must be one of the following: ascending (rising), descending (falling), or level (flat).
7. Take a Step Back
Divergence signals are typically accurate over longer periods. Additionally, we will receive fewer misleading signals.
This results in fewer trades, but the profit potential is enormous if the structure is sound. Divergences over shorter periods are more likely to occur but are less dependable.
FAQs
What is the Difference Between Divergence and Confirmation?
Divergence occurs when the price and the indicator provide contradictory information to the trader. Confirmation occurs when the indicator and the price, or many indicators, communicate the same message to the trader. In an ideal world, traders would like confirmation before entering and during trading. If the price increases, they want their indicators to indicate that the upward trend is likely to continue.
How to Avoid Trading Divergences Too Early?
Await a crossover of an indicator.
This is less of a trick and more of a rule. Watch for a momentum indicator crossover. This would imply a shift in momentum away from purchasing and selling. The primary reason for this is that the top or bottom cannot be produced without a crossover.
Allow the indicator to exit the overbought/oversold zone.
Another technique is to wait for momentum highs and lows to achieve overbought and oversold levels, at which point the indicator will exit these levels. This is identical to the reason for waiting for a crossover — you truly have no idea when momentum will begin to shift.
Bottom Line
Divergence occurs when the price behavior of an instrument contradicts the movement of an indicator. Divergence is a potent reversal indicator in stock trading, as it can signify the start of a new trend.
Trading divergences is one of the numerous trading methods employed by experienced traders. Indeed, it is a regularly employed strategy, particularly among seasoned Wall Street titans. To trade it successfully, all you need to do is pick the indicators you will use, understand them, and then practice on a demo account.
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