How to Trade Divergences

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Trading Divergence and Understanding Momentum

Because trends are composed of a series of price swings, momentum plays a key role is assessing trend strength. As such, it is important to know when a trend is slowing down. Less momentum does not always lead to a reversal, but it does signal something is changing, and the trend may consolidate or reverse.

Price momentum refers to the direction and magnitude of price. Comparing price swings helps traders gain insight into price momentum. Here, we’ll take a look at how to evaluate price momentum and show you what divergence in momentum can tell you about the direction of a trend.

Key Takeaways

  • Price momentum is measured by the length of short-term price swings—steep slopes and a long price swing represent strong momentum, while weak momentum is represented by a shallow slope and short price swing.
  • Momentum indicators include the relative strength index, stochastics, and the rate of change.
  • Divergence—the disagreement between indicator—can have major implications for trade management.

Defining Price Momentum

The magnitude of price momentum is measured by the length of short-term price swings. The beginning and end of each swing is established by structural price pivots, which form swing highs and lows. Strong momentum is exhibited by a steep slope and a long price swing. Weak momentum is seen with a shallow slope and short price swing.

For example, the length of the upswings in an uptrend can be measured. Longer upswings suggest the uptrend is showing increased momentum, or getting stronger. Shorter upswings signify weakening momentum and trend strength. Equal-length upswings mean the momentum remains the same.

Price swings are not always easy to evaluate with the naked eye because the price can be choppy. Momentum indicators are commonly used to smooth out the price action and give a clearer picture. They allow the trader to compare the indicator swings to price swings, rather than having to compare price to price.

Momentum Indicators

Common momentum indicators for measuring price movements include the relative strength index (RSI), stochastics, and rate of change (ROC). Figure 2 is an example of how RSI is used to measure momentum. The default setting for RSI is 14. RSI has fixed boundaries with values ranging from 0 to 100.

Momentum can be calculated by using the formula:

Where CP is the closing price and CPx is the closing price “x” number of periods ago.

For each upswing in price, there is a similar upswing in RSI. When price swings down, RSI also swings down.

Figure 2: Indicator swings generally follow the direction of price swings (A). Trendlines can be drawn on swing highs (B) and lows (C) to compare the momentum between price and the indicator.

Source: TDAmeritrade Strategy Desk

The study of momentum simply checks whether price and the indicator agree or disagree.

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Figure 3: Compare price and indicator to make better trading decisions.

Source: TDAmeritrade Strategy Desk

Momentum Divergence

Disagreement between the indicator and price is called divergence, and it can have significant implications for trade management. The amount of agreement/disagreement is relative, so there can be several different patterns that develop in the relationship between price and the indicator. For this article, the discussion is limited to the basic forms of divergence.

It is important to note there must be price swings of sufficient strength to make momentum analysis valid. Therefore, momentum is useful in active trends, but it is not useful in range conditions in which price swings are limited and variable, as shown in Figure 4.

Figure 4: In range conditions, the indicator does not add to what we see from price alone. Variable pivot highs and lows show range.

Source: TDAmeritrade Strategy Desk

Divergence in an uptrend occurs when price makes a higher high but the indicator does not. In a downtrend, divergence occurs when price makes a lower low, but the indicator does not. When divergence is spotted, there is a higher probability of a price retracement. Figure 5 is an example of divergence and not a reversal, but a change of trend direction to sideways.

Figure 5: Momentum divergence and a pullback. Higher pivot highs (small orange arrows) signal price support.

Source: TDAmeritrade Strategy Desk

Divergence helps the trader recognize and react appropriately to a change in price action. It tells us something is changing and the trader must make a decision, such as tighten the stop-loss or take profit. Seeing divergence increases profitability by alerting the trader to protect profits.

Technical traders generally use divergence when the price moves in the opposite direction of a technical indicator.

Take note of the stock from Figure 5, Chesapeake Energy (CHK), in which shares pulled back to the support. The chart in Figure 6 (below) shows trends do not reverse quickly, or even often. Therefore, we make the best profits when we understand trend momentum and use it for the right strategy at the right time.

Figure 6: Trend continuation. Agreement between price and the indicator give an entry (small green arrows).

Source: TDAmeritrade Strategy Desk

Four Commonly Used Indicators In Trend Trading

Managing Divergence

Divergence is important for trade management. In Figure 5, taking profit or selling a call option were fine strategies. The divergence between the price and the indicator lead to a pullback, then the trend continued. If you look at the pivot the price makes below the lower trendline, this is often referred to as a bear trap, where the false signal draws in shorts and price quickly reverses. The signal to enter appeared when the higher low in price agreed with the higher low of the indicator in Figure 6 (small green arrows).

Divergence indicates something is changing, but it does not mean the trend will reverse. It signals the trader must consider strategy options—holding, selling a covered call, tightening the stop, or taking partial profits. The glamour of wanting to pick the top or bottom is more about ego than profits. To be consistently profitable is to pick the right strategy for what price is doing, not what we think price will do.

Figure 7: Divergence results in range.

How To Trade With Hidden Divergences Video Tutorial

Divergence is an important leading signal.

A divergence signal develops when price leads or lags the indicator.

There are 2 types of divergences. Regular and Hidden.

Regular divergence is an important trend reversal signal.

Sometime it can be a retracement instead of a trend reversal.

However hidden divergence is more important than regular divergence.

Hidden divergence is always a trend continuation signal with a higher accuracy as compared to regular divergence.

You look for hidden divergence at the end of a retracement.

Hidden divergence tells you that the trend is going to continue in the original direction now.

Divergence in cryptocurrency market. How to use divergence in technical analysis of cryptocurrency? How to identify? How to trade?

What is divergence? How to identify it? How to apply it in technical analysis? How to trade it? You will find the answers to these questions in this post.

Divergence! It is a keystone of technical analysis, which is neglected by many, though it shouldn’t be. Why? Read on.

I continue my series of training posts, and this time, I would like to speak about divergences.

You are likely to have come across this notion in the reviews of analysts and traders, but I don’t think that you have studied this topic in detail.

Everybody knows that divergences are divided into bullish and bearish. But how many types of divergence can you enumerate?

The answer is three.

The term of divergence is quite common and is widely used in mathematics, physics, biology, linguistics. Its nature is the same everywhere and comes from Latin ‘divergo’, that means ‘deviate’.

In technical analysis, divergence occurs when an indicator and the price of an asset are heading in opposite directions.

The advantage of divergence in technical analysis is that, unlike most signals, divergence is a leading one.

The principle of this signal is rather simple. If it has appeared, the trend is likely to reverse soon, or, at least, the market is likely to move sideways.

Therefore, bearish divergence will mean the price reversal downwards, and bullish one will mean that the price will reverse upwards.

Divergence signal is relevant in all timeframes, but like for most signals, the subordination law works here as well. That is, divergence in a longer timeframe is a stronger signal than that in a shorter one.

If we discuss Bitcoin in this respect, I can say, based on my own experience, that the most suitable timeframe to identify divergences is 12-hour one.

It is difficult for me to explain, why, but exactly in this timeframe the signals work the most efficiently.

To look for divergence signals, I use a number of oscillators, such as:

  • Chaikin oscillator
  • DeMarker
  • MACD
  • Stochastic
  • RSI
  • Volume oscillator.

Why do I use exactly them?

Because, each of them is unique in a way, has its own features and the limit of sensitivity in different market conditions.

You can use any other oscillator, convenient for you, as in this post, I primarily aim at describing the very nature of Divergence signal and how to correctly read it in the chart.

So, as I have already said, there are three types of divergence, they are:

  • Regular Divergence (opposite to the trend),
  • Hidden Divergence (following the trend),
  • Extended Divergence.

Besides, it should be remembered that divergence is relevant solely until the next extreme is formed, after that, it loses its relevance.

Example of Regular (opposite to the trend) divergence

In the chart above we see an example of regular BEARISH divergence, that is also called the divergence, opposite to the trend.

The principle of the signal is based on its name.

In the chart above we see, although all-time highs are being renewed within the bullish trend, the oscillators, Chaikin, Volume and RSI, show highs lower than the previous ones.

For presentation purpose, I marked this signal with blue arrows.

As we see from the history, this signal 100% worked out, and the people who followed this signal, left the market on time, having sold their bitcoins at all-time highs.

In case of regular BULLISH divergence, the signal works according to the same principle, that is the indicator, despite the market lows renewals, will show higher lows.

Example of Hidden (following the trend) divergence

In the chart above we see a good example of the opposite divergence, which is also called hidden divergence, or following the trend divergence.

Beginners often confuse Hidden Bearish divergence with Regular Bullish one, which results in bad mistakes. Traders open long positions, when, on the contrary, they should look for short ones.

In the chart above, it especially clearly identified by DeMarker, MACD and RSI, that there is this tricky Hidden BEARISH divergence.

Its principle is opposite to the regular divergence; here, an oscillator shows higher highs, which the price fails to reach.

As you see, this signal had also perfectly worked out, and the market, following the signal, slipped down into the correction.

For Hidden BULLISH divergence, everything is visa versa; an indicator shows lower lows, when the price fails to reach them.

An example of Extended divergence

Extended divergence often occurs during the market moving sideways, when there are not so many highs and lows. It also occurs when Double Bottom or Double Top patterns are forming, being a perfect confirming signal of the trend reversal.

In this case, one needs to follow, what value indicates an oscillator, when the price reaches the border of the lateral (side-way) channel.

In the chart above, we see that the price had only reached the previous low, when Volume oscillator and DeMarker showed the higher lows.

This signal is Extended BULLISH divergence.

Extended BEARISH divergence based on the same principle. It occurs when the price highs are at the same level, but an oscillator fails to indicate the previous highs and showed the highs, lower than the previous ones.

What’s now?

To analyze the situation accurately and find out divergences, it is necessary to follow an asset moves in all timeframes, from the weekly one to the hourly one.

Let’s try to analyze our dear Bitcoin in this respect.

As wee see, in the weekly chart, there are weak attempts to form regular bullish divergence on volume oscillator.

This oscillator is one of the most sensitive, so, its signal always need proofs.

As wee see, the rest of oscillator are still following the market, and only Chaikin oscillator gives a signal, suggesting that a divergence is likely to form.

In combination, this signal can be a sign of weakening correction and a soon beginning of the end, or at least a pause, of the bearish trend.

In the daily chart, the situation hardly clarifies.

We see that volume oscillator has already started renewing the highs, although the market is still moving downwards.

However, the other indicators don’t give strong reversal signals.

That means, this slight rollback that is developing now, can well be the result of the single signs, indicated by volume oscillator.

In 6-hour chart, the situation looks even worse.

As we see in the chart above, there is bearish divergence, indicated by Chaikin and volume oscillators, it is already quite a good reason for correctional move.

In 4-hour chart, bearish trend is confirmed by DeMarker.

As we look for divergence by comparing the price move and the indicators, for more clarity, I recommend using Zig Zag. It highlights the local extremes in the price chart, which makes the analysis easier for beginners.

Don’t forget, to look for divergences in a bearish trend, we compare lows, and in a bullish trend – highs.

The divergences themselves should be only seen as a confirming, complementary signals for your trading strategy.

Opening a position, based on solely a divergence signal, involves extreme risk!

A good combination of the analysis of divergence with trading strategies is the use of this analysis in channel trading.

See the example in the chart above.

Now, the market is moving in a descending channel, and bearish divergence in 4-hour chart indicates that this channel is unlikely to be broken out from below. Therefore, when the price rebounds from the upper channel border, short positions can be opened with essential following money management rules and setting stop loss orders.

I wish you good luck and good profits!

P.S. Did you like my article? Share it in social networks: it will be the best “thank you” :)

Ask me questions and comment below. I’ll be glad to answer your questions and give necessary explanations.

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The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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