Trading with Divergences

Learning how to trade with divergences can sometimes be a little daunting. Not only do you have to know what the main kinds of divergences are, but they do not always guarantee the projected outcome a divergence will signal. Executing a trade with divergences and only divergences is never a wise trading decision. Divergences, while powerful, should only be used as a confirmation tool.

are simply when you see price moving in one direction and, typically an oscillating indicator, move in different directions. Basically, if you see the price going up and making new higher highs, but the oscillator is making new lower lows, you have a divergence. Let’s look at some examples of four common kinds of divergences.

The first we will observe is a bullish divergence or a regular bullish divergence. I will be using the RSI as the oscillator for this example.

 

You will notice that there are similar and repeating patterns associated with these moves. In a regular bullish divergence, you are going to typically spot this near the end of a down trend. Divergence theory indicates that there is a strong probability of price reversing. Notice how prices have made lower lows but the RSI has made higher lows. Price did the reverse, tested a swing high and then the previous swing low and then continue to drive higher before entering a new down trend and creating another, more obvious regular bullish divergence.

Now let’s observe a regular bearish divergence.

 

Essentially, bearish divergences are going to signal downwards movement. Just as in a regular bullish divergence pattern we see it from near the end of a down trend, in a regular bearish divergence pattern we see this form at the end of an uptrend. The divergence we see is that price has made a higher high (on this chart it made quite a leap) but on the RSI oscillator, we have lower highs. Divergence theory with this regular divergence pattern indicates a high probability of price reversing to the downside.

The next two examples of divergences are called hidden divergences. I know that can sound confusing, it was confusing to me when I first started trading! But hidden divergences only mean that there is a divergence with in a trend. So, while regular divergences indicate a reversal of trending price action, hidden divergence is an indication that the trend will continue. I like to think it as identifying a fake out or the end of a pullback.

The first hidden divergence we will look at is hidden bullish divergence.

 

In this example of a hidden bullish divergence, notice how we are in an uptrend. Further, we continue to make higher lows, but the RSI oscillator is making lower lows. A trade with hidden bullish divergence signals there is a strong probability of price continuing the uptrend. Pay close attention to the higher low formed a the end of the arrow, price action with candlestick patterns can confirm the continued trend. It appears to be a tweezer bottom at the end of this hidden bullish divergence. And we see price did continue to the upside.

The next and last type of trade with divergence is the hidden bearish divergence.

 

In this example, we see that while prices have continued to go lower and formed lower highs, the RSI oscillator has made higher highs. This is what is called a hidden bearish divergence. Divergence theory tells us that there is a strong probability that the down trend continues. Again, a hidden bearish divergence pattern means that the trend is continuing to the downside. I drew this head and shoulders pattern just to show how price reacted to the formation of this common pattern and how the lower high failed to push beyond the right shoulder. That was another confirmation tool of trend continuation.

So again, in summary, these are the four divergence patterns we discussed.

Regular Bullish Divergence

  • End of a down trend.
  • Second bottom.
  • Price makes new Lower Low, but oscillator makes Higher Low.
  • Trend changes to the upside.

Regular Bearish Divergence

  • End of an uptrend.
  • Second top.
  • Price makes Higher High, but

oscillator makes Lower High.

  • Trend changes to the downside.

 

Hidden Bullish Divergence

  • During an
  • Once price makes a Higher Low, but oscillator makes a Lower Low.
  • The trend should continue to the upside.

Hidden Bearish Divergence

  • During a downtrend.
  • Once price makes a Lower High, but oscillator makes Higher High.
  • The trend should continue to the downside.