Divergence is an important concept because it suggests that the trader can look beyond the first impression created by a chart, or market activity. When the crowd roars at a football match we cannot tell which team kicked the goal, nor if this is a goal added to a high, or a low score. The roar tells us something happened, but we need additional information to determine its importance. When the roar comes after a low score, we know to ignore it because the goal is not a winning goal for a team that is so far behind. We see a divergence - nice roar, but a lousy single goal. If the roar is for a goal which takes the team to within a point of winning, then the facts support the case and we pay greater attention.
Divergence warns us that all may not be as it seems on the surface.
Most technical indicators mirror price movements, since their calculations are based on the price movement. When price rallies, the indicator moves up and when price moves down, the indicator moves down. This is the reason why most indicators are said to be lagging. Very few indicators have characteristics which can be defined as leading, and among them the divergences are one of the most effective.
Divergences occur when there is a discrepancy between the price and a technical indicator.
This discrepancy or divergence is usually seen on the oscillator type of indicators, such as the RSI, MACD, and Slow Stochastic etc. It stands out among these indicators, which typically have an overbought/ oversold value, as well as those which move above and below a zero line.
The most common type is the Classic or Regular Divergence which is a reversal pattern. The Regular divergence is a separation between the price and the indicator, which warns of a possible short or medium term change of trend. It can be defined as –
Higher highs in price and lower highs in the oscillator which indicate a trend reversal from up to down. This is known as the Bearish Divergence.
Lower lows in price and higher lows in the oscillator which indicate a trend reversal from down to up. This is known as the Bullish Divergence.
These divergences usually occur at price tops or bottoms, and even at price corrections. The chart shows the typical Bullish and Bearish Regular Divergences.
While this Regular Divergence is more commonly used, there is another type of divergence which is not used as regularly, but is far more effective. It is called a Hidden Divergence, which is also a discrepancy between the price and an indicator, except that this is a continuation pattern.
The Hidden Divergence pinpoints entries in an existing trend, and since it is a pattern which gets a trader into a prevailing trend, it gives a better profit potential. It can be defined as –
Lower highs in price and higher highs in the oscillator which indicate a confirmation of the price trend which is down.
Higher lows in price and lower lows in the oscillator which indicate a confirmation of the price trend which is up.
Hidden Divergences are the opposite of Regular Divergences, but offer a greater potential, since they indicate entries which are in the direction of the trend.
In a Regular Bearish Divergence, a trader would look for higher highs in price and lower highs in the oscillator at price tops, which would indicate a trend reversal from up to down. The disadvantage of this setup in a well established trend is that this discrepancy could turn out to be a minor retracement of the trend. Taking a correct call on a regular divergence setup becomes a tricky affair, since identifying a top or bottom is akin to catch a falling knife.
On the other hand, for a Bullish Hidden Divergence, a trader would look for higher lows in price and lower lows in the oscillator, which would indicate a continuation of the trend to the upside. The advantage is that this setup is giving the trader an exact entry point into a continuing trend, which is a far better proposition than “catching a falling knife”. And the trader is following the Golden Rule – “The trend is your friend.”
I prefer the Hidden Divergences since we are trading with the trend, and we can define our entries, exits and stops clearly. In case of a Bullish Hidden divergence, we first identify the two higher low pivot bars, which creates the lower lows in the oscillator. We place our entry orders above the high of the second pivot bar (the second bar which has the higher low), and our stops beneath the low of the same bar. We exit the trade, when the stochastic has reached the overbought level, and the stochastic lines have crossed in the downward direction.
For a Bearish Hidden Divergence we simply reverse the rules. Looking at the same chart example, we can identify the Hidden Divergences and the exact entries and exits.
Both the Regular and Hidden Divergences occur quite frequently, across all time frames. If one has the patience to wait for a Divergence pattern to develop, and the discipline to take trades only on a Divergence setup (especially the Hidden Divergence), and nothing else, one could be a very successful trader.
Article as published in the Guppytraders.com weekly newsletter, October 11th, 2006 edition.
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