Regular and Hidden Divergences
Updated: Sep 16, 2020
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.