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Divergence in Trading: Definition, Types, Importance, Trading Example, Limitations          

Divergence in Trading: Definition, Types, Importance, Trading Example, Limitations

Divergence in Trading: Definition, Types, Importance, Trading Example, Limitations
By Arjun Arjun Remesh | Reviewed by Shivam Shivam Gaba | Updated on March 26, 2024

Divergence in trading is a break between the price action of a security and an oscillator. Divergence in trading refers to scenarios where the price of an asset and its momentum, as measured by an indicator such as RSI or MACD, do not confirm each other’s direction. There are two main types of divergences seen in trading – hidden and reverse divergences. Understanding divergence is important for traders as it helps identify periods where the existing trend could potentially reverse. One of the main advantages of divergence is that it can signal trend reversals before they occur on the price chart.

However, one limitation is that divergence signals are not always effective and at times, price action may not confirm the signal, leading to false signals. The three common types of divergences seen in trading are hidden divergence, reverse divergence and bearish divergence. Hidden divergence occurs when the indicator makes a new high, but the price charts fail to surpass the earlier high. Reverse divergence happens when the indicator prints a new low along with rising prices. Bearish divergence is formed when the price makes a higher high, but the indicator prints a lower high, signaling weakness. It is important for traders to understand these divergences well to better time their entry and exit from trades.

What is divergence in technical analysis?

Divergence refers to a situation where the price of an asset is moving in the opposite direction of a technical indicator, such as an oscillator. Divergence occurs when the price of a stock makes new highs or lows that are not confirmed by the indicator. Divergence warns that the current price trend is weakening and, in some cases, leads to the price changing direction. Traditional divergence occurs when prices are making new highs while an oscillator is failing to exceed its previous highs. This divergence between price and oscillator often foreshadows a turning point. Identifying divergence on a chart helps technical analysts spot potential reversals and trading opportunities.

What does divergence indicate?

Divergence indicates a discrepancy between price action and an oscillator or other indicator. Divergence shows that momentum is slowing and that a trend is nearing exhaustion. The divergence suggests that demand and supply are shifting, which could lead to a trend reversal. Identifying divergences helps traders spot turning points and potential opportunities to enter counter-trend trades. Divergence in technical analysis signals a major positive or negative price move. A positive divergence occurs when the price of an asset makes a new low while an indicator, such as money flow, starts to climb. Conversely, a negative divergence occurs when the price makes a new high, but the indicator being analyzed makes a lower high. 

How many types of divergence are there?

Divergences are of four main types. Bullish divergence happens when price makes lower lows, but momentum makes higher lows, signalling an uptrend is ahead. Bearish divergence is the opposite, with price making higher highs but momentum making lower highs, signalling a potential downtrend. Hidden divergence is similar but uses intra-period instead of closing prices. False divergence appears to be bullish or bearish but then quickly reverses.

1.Bullish Divergence

A bullish divergence is when share prices decline to a new trough while a momentum indicator does not make a fresh low. This scenario shows that bears are weakening in force, and bulls are poised to take over the market soon again – frequently, a bullish divergence signals the conclusion of a downward trajectory. As prices hit novel bottoms, momentum’s inability to mirror this hints at accumulation and imminent upward thrust. Thus, a bullish divergence commonly foreshadows an approaching upturn reversal in the equity’s course.

Bullish Divergence
Divergence in Trading: Definition, Types, Importance, Trading Example, Limitations 16

This chart shows a bullish divergence pattern forming between the price of the asset and its RSI indicator. While the price is making a lower low, the RSI is forming a higher low, showing a break in the normal correlation between the two. This indicates that despite the decline in the price of the asset, its underlying momentum is decreasing to a lesser degree. Such a bullish divergence suggests that the prevailing downward movement in price may be temporary, and the asset could be poised to change direction to the upside

2. Bearish Divergence

A bearish divergence materializes when share pricing ascends to fresh peaks, whilst a technical indicator constructs inferior apexes. Despite an ostensible bullish sentiment in the market, this discrepancy intimates waning momentum. Consequently, a steep downward correction in the equity price is prone to ensure apace. A bearish divergence transpires when the underlying stock registers higher highs aligned with lower highs in an oscillator, betraying fragility in the uptrend.

Bearish Divergence
Divergence in Trading: Definition, Types, Importance, Trading Example, Limitations 17

This chart displays a technical pattern where the price is forming higher highs, but the oscillator is forming lower highs. This break between the movement of price and the indicator suggests that upward momentum is weakening despite the asset reaching new peaks. The declining peaks on the oscillator serve as an early warning that upside movement may soon run out of steam. The formation of lower highs on the oscillator in contrast with higher highs on price signals that bearish pressure may be building. 

3. Hidden Divergence

Hidden divergence materializes when price activity conflicts with oscillator readings on an intra-period basis rather than utilizing closing values. By overlaying an equity’s performance with metrics like RSI, MACD, or Stochastics, hidden divergence exposes subtle momentum shifts that are antecedent to trend rotations. Though undulatory within a prevailing trend, hidden divergence betrays waning participation and augurs an imminent inflexion point. Hidden divergence identifies potential trend extension or reversal through intraday oscillator analysis.

Hidden Divergence
Divergence in Trading: Definition, Types, Importance, Trading Example, Limitations 18

This chart displays a hidden divergence developing between the asset price and its momentum indicator. While the price is reaching new highs, the oscillator is forming lower peaks. The divergence signals that upward movement may be losing strength despite the asset hitting fresh highs. The declining highs on the indicator compared to advancing highs on price implies underlying bearish pressure could be incrementally increasing. 

4. False Divergence

A false divergence materializes when an equity’s price and indicator seem to diverge, but the extant trend does not reverse as anticipated. Despite ostensibly satisfying divergence criteria, the momentum aberration swiftly normalizes, and the price continues with its prior bearing. While momentarily suggesting trend exhaustion, false divergence’s indicator and price promptly reconverge to sustain the preceding movement. In essence, false divergence briefly mimics authentic divergence but fails to manifest a durable trend shift.

Thus, divergence signifies momentum disparities presaging potential trend shifts, manifesting in four distinct forms for technical analysis interpretation.

How do we spot divergence?

Technical indicators like the Relative Strength Index, Moving Average Convergence Divergence, Stochastic Oscillator, and Awesome Oscillator identify divergence by showing the price moving in an opposite direction from the indicator, signalling potential trend changes and reversal points.

1. Spot divergence using RSI

Positive divergence forms when the price makes a lower low while the RSI forms a higher low. This indicates rising bullish momentum and signals that the downtrend is weakening. Negative divergence occurs when the price makes a higher high while the RSI forms a lower high. This shows waning upside momentum and suggests the uptrend could be losing strength. Divergence signals a potential trend reversal, so traders watch for separation between price and RSI to anticipate turning points. RSI divergence does not guarantee a turnaround but provides an early warning sign when used along with other indicators. Detecting divergence with RSI helps traders prepare for a possible shift in the existing trend in a stock.

2. Spot divergence using MACD

Positive MACD divergence happens when the price of a stock makes a lower low while MACD forms a higher low. This divergence between price and indicator suggests downside momentum is weakening and foreshadows a bullish reversal. Negative divergence occurs when the price registers a higher high, but MACD prints a lower high. This bearish divergence signals that upside momentum is faltering and indicates a potential peak in the uptrend. MACD divergence clues traders into a possible trend change ahead of the price reversal. However, divergence alone is not an outright signal but rather an early warning of trend exhaustion to watch for. Analyzing the relationship between price and MACD tip-off traders to an impending shift in the stock’s trend.

3. Spot divergence using a Stochastic Oscillator

Positive divergence forms when the price of a stock makes a lower low while Stochastic produces a higher low. This suggests downside momentum is waning and could foreshadow a bullish reversal. Negative divergence transpires when the price registers a higher high, but Stochastic prints a lower high. This indicates fading upside momentum and hints that an uptrend is nearing exhaustion. The divergence between Stochastic and price action tips off traders to a potential trend change ahead. However, divergence alone is not an outright signal but rather an early alert of trend weakness to watch for. Comparing price action to the Stochastic Oscillator provides an early warning of an impending trend shift in a stock.

4. Spot divergence using Awesome Oscillator

Positive divergence occurs when the price of a stock makes a lower low while the Awesome Oscillator forms a higher low. This suggests downside momentum is waning and could signal an upcoming bullish reversal. Negative divergence materializes when the price prints a higher high, but the Awesome Oscillator produces a lower high. This indicates fading upside momentum and hints that an uptrend is approaching exhaustion. The divergence between the Awesome Oscillator and price action alerts traders to a potential trend change in the making. However, divergence alone is not an outright signal but rather an early warning of trend weakness to watch for. Comparing price action to the Awesome Oscillator provides advance notice of an impending trend shift in a stock.

Accordingly, savvy traders utilize oscillators to ascertain divergence, presaging impending trend shifts through momentum analysis.

Why is understanding divergence important?

Understanding divergence is important as it provides critical insights for trade entries and exits. It serves as confirmation, identifies reversals, and helps avoid false signals. Spotting divergence aids timing, maximizes profits, and minimizes losses. Mastering divergence analysis strengthens overall trading skills.

  • Early warning signals

Divergence provides early warning signals of potential changes in stock trends. Divergence is revealed when price and indicator momentum are moving in opposite directions. This divergence signals an upcoming shift in market sentiment before a new trend emerges. By spotting divergence early, traders anticipate and prepare for trend reversions in stocks. Analyzing divergence gives traders an edge by detecting subtle changes in market momentum before major price trend shifts occur.

  • Confirmation of Trends

Divergence also validates emerging trends in stock prices. It gives traders added confidence in the direction of the market when divergence confirms the current price trend. Divergence reinforces the momentum behind a trend, signalling that it is likely to continue. By confirming trends, divergence helps traders avoid premature exits and stick with winning positions longer. Analyzing divergence provides objective evidence that the prevailing trend has underlying strength and validity.

  • Identifying Reversal Points

Divergence pinpoints potential reversal points in stock trends. Divergence at key support and resistance levels alerts traders to an impending shift in price direction. By identifying when divergence occurs near turning points, traders prepare to exit existing trades. Analyzing divergence reveals when bullish or bearish momentum is losing steam despite the price continuing to trend. Spotting divergence allows traders to anticipate and capitalize on trend reversals at critical junctures in the market.

  • Avoiding false signals

Divergence also helps traders avoid acting on false signals. Properly interpreting divergence reduces whipsaws by filtering out misleading indicator readings. Knowing how to validate divergence with other technical analysis tools decreases bad trades. Learning the principles behind divergence assists traders in distinguishing real signals from fake ones. Analyzing divergence properly minimizes unnecessary market noise and false positives.

By analyzing the divergence between price and indicator momentum, traders detect subtle shifts in market sentiment before new trends emerge. Spotting divergence gives traders an edge to prepare for trend reversions, stick with valid trends longer, and capitalize on upcoming turning points.

How do we trade divergence?

Take a look at the below chart to understand how to trade divergence. 

How to trade divergence?
Divergence in Trading: Definition, Types, Importance, Trading Example, Limitations 19

The chart displays a bullish divergence developing between the price of the asset and its RSI indicator. As the price makes a series of lower lows, the RSI is forming higher lows, suggesting that downward momentum may be slowing even as the price decreases. This could imply that the downward movement in price may only be temporary. Additionally, hidden divergence is shown developing with the asset price reaching new highs, but the momentum indicator forms lower peaks. The declining highs on the indicator compared to the advancing highs in price imply that underlying bearish pressure may be building incrementally. 

Traders look for opportunities to enter long positions when the price confirms a bullish divergence signal through a reversal higher. It’s important not to rely solely on divergences, as they don’t guarantee reversals. Close stops should be used to mitigate risk. Additional technical tools may provide increased confidence when corroborating signals. Backtesting divergence strategies is recommended to assess real-world performance over time.

What are the common mistakes to avoid while trading divergence?

The common mistakes to avoid while trading in divergence are ignoring confirmations, overlooking the larger trend, isolating divergence, and not waiting for validation. Mistakes using divergence lead to failed trades.

  • Ignoring Confirmation Signals

It’s important not to act on a divergence signal alone without confirming it through other technical analysis methods. Look for confirming signals like breakouts, moving average crosses, or chart patterns to validate the divergence before entering a trade. Acting on divergence in isolation leads to premature entries and stopouts. Use complementary indicators like RSI, MACD, or stochastics to confirm the momentum shift suggested by the divergence. Entering a trade on divergence alone leaves you prone to false signals, so wait for confirmation from additional indicators before pulling the trigger.

  • Overlooking the Overall Trend 

It’s critical to consider the prevailing trend on larger time frames when trading divergences. A bullish divergence forms in a strong downtrend, signalling only a corrective bounce rather than a trend reversal. Similarly, a bearish divergence during an uptrend marks only a pullback before prices resume climbing. Always zoom out to higher time frames and assess the overall trend context before trading a divergence on smaller time frames. Going against the dominant trend is risky, even with a divergence signal.

  • Using Divergence in Isolation

Divergence by itself is not a complete trading system – it should be combined with other technical analysis tools. Using divergence signals in isolation leads to whipsaws and false signals. However, divergence turns into a potent confirmation tool when combined with momentum oscillators, trend lines, chart patterns, and moving averages. Consider the whole technical picture, watch for indications of confirmation, and combine divergence with additional indicators. Divergence alone is not enough for high-probability setups.

  • Not Waiting for Confirmation

One of the biggest mistakes is acting prematurely on a divergence signal before waiting for confirmation. This often leads to premature entries, false signals, and being stopped out of trades. Before trading a bullish or bearish divergence, wait for confirmation from a break of trend lines, moving average crosses, or classic chart patterns. Do not enter on divergence alone – be patient and wait for secondary indicators to confirm the signal before pulling the trigger. Acting too quickly leads to trading errors.

Avoiding mistakes like acting on unconfirmed signals, ignoring the trend, and isolating divergence is key. Apply divergence cautiously, wait for validation, and combine it with other indicators for high-probability setups.

How do you confirm divergence?

Divergence is confirmed by looking for confirmation signals that support the initial divergence pattern observed on the chart. Confirmation signals include candlestick reversal patterns in the direction of the divergence, like a doji or hammer candle indicating a reversal after bearish divergence. Trendlines and support/resistance levels that align with the divergence signal also help confirm divergence, like a break of support reflecting bearish divergence. Volume levels decreasing as the price continues higher supports bearish divergence, confirming that buying power is waning.

Technical analysis emphasizes the importance of looking for reversal patterns that support the divergence signal (e.g., double tops or double bottoms) within the framework of technical analysis. MACD histogram bars decreasing while the price is making higher highs also confirms bearish divergence, a key concept in technical analysis. Use trendlines, support/resistance levels, or candlestick patterns in the direction of the prevailing trend to confirm the hidden divergence. Multiple technical indicators, reflecting divergences in their oscillations like RSI and MACD, provide stronger confirmation signals, further illustrating the critical role of technical analysis in identifying and confirming potential market movements.

What is the success rate of divergence?

Divergence trading has a 74% success rate when using the MACD indicator over a six-month period, as the longer time frame allows divergences to fully play out. However, bullish divergence is more likely to fail than succeed in the short term, with a success rate between 50% at three weeks and 55% at three months. The success rate of divergence trading varies greatly depending on the time frame and indicators used. To improve the odds, traders should combine MACD with other indicators like RSI to look for confirmation and focus on daily or weekly charts rather than very short time frames under 30 minutes.

The type of divergence also impacts success rate, with regular divergence tending to perform better than hidden divergence with a gap between 65-75%. Divergence trading takes patience and combining indicators to achieve consistent success, with ideal holding periods between 1-6 months and aim for at least a 60% success rate. Traders should backtest strategies, use proper risk management and avoid overtrading divergences to benefit from this pattern.

What timeframe is best for divergence?

The best timeframe for trading divergences depends on your trading style, but the most reliable signals form on daily and weekly charts. Divergences in shorter time frames, like 15 minutes or 1 hour, will occur more frequently but will have lower accuracy and success rates. Traders using fast strategies look for divergences on 15-minute charts, but most will find that 1-hour charts provide the best mix of actionable signals versus noise.

For swing trades or investments, daily and weekly charts are ideal for spotting high-probability divergence setups. The longer the time frame, the more powerful the divergence tends to be, as it takes time for momentum to shift noticeably. Experienced traders only look for divergence on daily and weekly charts, as shorter timeframes have too much noise and whipsaws. In general, focus on timeframes of 4 hours or longer when scanning for divergence setups, and always use other indicators to confirm signals.

What are the limitations of divergence?

The limitation of divergence is that it produces false signals, especially in volatile markets when the divergence is just temporary. Divergence also does not precede every price reversal, as it reflects a discrepancy between price and momentum, but not all reversals are momentum-driven. Additionally, divergence is not foolproof, so it should not be used as the sole indicator for trades but rather to complement other signals. Interpreting divergence requires subjective pattern recognition, so traders draw different conclusions from the same chart data.

Divergence works best for confirming trend reversals, not predicting new trend starts or calling tops and bottoms precisely. Since divergence signals take a long time to develop and play out, they lack effectiveness for very short-term trading. Divergence trading strategies should be backtested and optimized, as the success rate varies greatly based on parameters like timeframes and indicator settings.

Is divergence bullish or bearish?

The direction of divergence, either bullish or bearish, depends on the relationship between the price action and the indicator. For regular or positive divergence, which is bullish, the indicator is making new lows while the price forms higher lows. For hidden or negative divergence, which is bearish, the indicator forms higher highs while the price is putting in lower highs. Bullish divergence reflects building upside momentum, so it signals an upcoming uptrend. Bearish divergence reflects waning momentum, pointing to a potential downtrend ahead. Traders look to enter long trades on bullish divergence when the price confirms the signal with a break above resistance. Short trades are taken on bearish divergence after the price breaks below support. 

Is divergence strategy good?

Yes, the divergence strategy is quite effective for stock trading when used properly. Divergence signals on longer time frames like daily or weekly charts tend to be more accurate with fewer false signals. This results in fewer trades, but the profit potential on each trade is substantial if you manage risk and structure the trade correctly. On shorter time frames like hourly charts, divergences occur more often but tend to be less reliable. Divergence is a powerful tool but should be combined with other confluence factors for the highest probability setups. Using it selectively on higher time frames allows you to capitalize on major trend reversals while avoiding whipsaws from false signals. With the right application, divergence boosts profits for swing and position traders.

Is divergence trading profitable?

Yes. Divergence trading has the potential to be profitable when applied judiciously. Research shows divergence signals between price and indicators often precede major trend changes in stocks. Traders use divergence to spot turns when the price diverges from momentum oscillators like RSI. The key is selectivity – divergences on daily or weekly charts tend to be more accurate, generating fewer false signals. However, divergences on shorter time frames occur more frequently but with less reliability.

False divergence signals lead to premature entries or exits, especially in volatile markets. To maximize profits, traders should focus on high-probability setups, confirm signals with other factors, and manage risk on each trade. With the proper strategy, divergence trading boosts results, but no indicator is perfect on its own. Discipline is required.

What is the best technical indicator for divergence?

The best technical indicators for divergence are oscillators like the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD). These momentum indicators are ideal for spotting divergence as their ebb and flow visualize positive and negative momentum. It signals bearish divergence and a potential trend reversal when the price makes new highs, but the RSI or MACD starts declining. It indicates bullish divergence if the price is making new lows, but the RSI or MACD starts rising.

Traders look for a separation between the indicator and price to confirm divergence. RSI and MACD are easy to use, customizable, and widely available on charts and trading platforms. Their accessibility makes divergence analysis achievable for traders at all experience levels. Combining these classic momentum oscillators with the potent chart pattern of divergence creates a straightforward yet powerful trading strategy.

Divergence cheat sheet

Divergence cheat sheet
Divergence in Trading: Definition, Types, Importance, Trading Example, Limitations 20

A bullish divergence occurs when the asset makes lower price lows while the oscillator forms higher lows, indicating downward momentum could be easing.

Bearish, or top, divergence is the opposite – as the asset hits higher highs, the oscillator forms lower highs, a potential sign upside momentum is waning.

Hidden divergence appears when new price highs are unaccompanied by confirming highs in the oscillator, suggesting the current uptrend may reverse.

Reverse divergence shows the asset rising while the oscillator falls to fresh lows, a signal the trend could change course going forward.

Arjun
Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam
Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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