Usually, traders use oscillators such as Stochastics, RSI, and CCI to find out overbought and oversold levels. But there is another way to use these oscillators. It is called divergence trading. It is basically comparing the direction of the indicator with the direction of the price. Usually, the direction of the indicator follows the direction of the price. But if there is any divergence in that, it can indicate potential trend reversals.
Divergence trading is a very powerful tool that traders can use to predict the overall market. It is often overlooked but can be very useful. You can use divergences as a leading indicator as it gives a signal before a new trend or a reversal. By making full use of divergences, you can earn consistent profits.
What Does Divergence Mean?
When price action makes higher highs, oscillators usually make higher highs too. The same applies to lower lows. But if they diverge from each other, it is called divergence. Divergences are helpful in indicating you that something suspicious is going on in the market. They prompt you to pay close attention to what is going on.
You can use it to notice if a trend is weakening or if there is any reversal in the momentum. It is also possible to see if a trend is going to continue.
It is of two types: regular and hidden
A regular bullish divergence occurs when the price is making a lower low but the oscillator is making a higher low. This usually happens when a downtrend is ending.
Let us say the oscillator fails to make a new low after a sequence of lower lows. Instead, the oscillator is starting to make higher lows. At this point, there is a divergence. Since we know that the price and momentum move in the same direction, we can anticipate the trend to reverse.
A regular bearish divergence occurs when the price is making a higher high but the oscillator makes a lower high. This usually happens when an uptrend is ending.
If an oscillator fails to make a new higher high after the price forms a higher high, a divergence is created. Since price has to follow the momentum, we can anticipate the uptrend to end.
This occurs when the price is making a higher low, but the oscillator is showing a lower low. This usually happens in an uptrend and indicates that the trend will continue.
Hidden Bearish Divergence happens when price makes a lower high (LH), but the oscillator is making a higher high (HH). This usually happens in a downtrend. It indicates that the downtrend will continue.
The first thing to do is to spot one. Here is an easy checklist for you. When you look for divergence, make sure that the price has formed one of the following:
- Higher high than the previous high
- Lower low than the previous low
- Double top
- Double bottom.
A divergence can exist only in the above four formations.
Here is the first thing to keep in mind! Regular divergences signal trend reversal whereas hidden divergences signal trend continuation. So, when you see a regular bearish one, be aware that this signals the reversal of an uptrend.
It is also important to avoid entering too early and wait for confirmation. For example, you can wait for a crossover of a momentum indicator as it indicates a shift in momentum. You can also wait for the indicator to reach overbought/oversold levels and move out of them.