In technical analysis, divergence occurs when a momentum indicator, like some oscillators, starts to go the opposite direction compared to the price action. This phenomenon shows a weakening in price momentum and signals possible pullbacks or even change in trends. The most used indicators for divergence trading are the RSI and the MACD.
There are four types of divergence: bullish (positive), bearish (negative), hidden bullish (positive) and hidden bearish (negative). The bullish (positive) divergence occurs when the price makes a new low, but the oscillator makes a high compared to the previous data. On the other hand, a bearish (negative) divergence occurs when the price makes a new high, but the oscillator makes a low compared to the previous data. These two types of divergence are also called regular.
Divergence using the MACD
The bullish (positive) hidden divergence happens when in uptrend the price makes a higher low, but the oscillator makes a lower low. On the other hand, a bearish (negative) hidden divergence happens when in a downtrend the price makes a lower high, but the oscillator makes a higher high. The hidden divergence can signal a continuation of the trend.
Divergence using the RSI
As previously mentioned, regular divergence signals a weakening momentum, and the price can either pullback or change completely the trend. There are different targets where the price can go to once a divergence works out. The first target is generally the previous swing point or a trendline and instead of taking a risky counter-trend trade you can use this opportunity to wait for the price to pullback to the swing point or the trendline and then trade a continuation of the original trend. Below you can see some examples where divergent price action pullbacks to trendlines and swing point before continuing the upside trend.
Divergent price action pullbacks
Another target of the regular divergence is the last swing point that technically defines a trend. Once the price breaks out of that swing point, the trend is said to be changed on that specific timeframe. Below you can see an example where the price pullbacks all the way up to that last swing point and then gets rejected almost perfectly before continuing the original downtrend. Again, instead of trying to catch the point when the price starts to go all the way up to the swing point, you can wait for it to complete the run and then entering in anticipation of the continuation of the trend to catch bigger moves and to limit better risk.
Last swing point as divergence target
The last usual target of the regular divergence can be the last swing point that began an entire divergent move. This generally happens with a chart pattern called wedge, which is divergent in nature.
The price goes up/down slowly with pullbacks getting smaller and smaller and the oscillator signalling a weakening momentum for the entire move which at some point just breaks out and goes all the way back to the swing point when the divergence started to occur. Below you can see an example of a wedge type divergence and the price pulling all the way back to the swing point when the divergence began. Curious fact is that before continuing the upside trend, there was another divergence that could confirm that level as a possible support for a continuation trade.
To sum up, divergence is a nice and handy technical analysis concept which can help in risk management and even timing. As you saw from previous examples, it’s not used on its own but complemented with other technical concepts like swing levels, trendlines and so on to give more structure.
This article was written by Giuseppe Dellamotta.