Divergence is not an indicator, nor that it is a mathematical study. However, it is considered a leading indicator among investors and financial analysts.
Divergence is when the price of a financial instrument is moving in a different direction of a technical indicator, such as ADXS, MACD, or is moving contrary to other data. Divergence suggests that the prevailing price trend may be weakening, and in some cases, may lead to the price changing direction (price reversal).
Investors and analysts talk of two types of divergence: regular divergence and hidden divergence. At the same time, there is a positive and negative divergence. Positive divergence symbolizes a move higher in the price of the financial instrument is possible. Negative divergence suggests that a move lower in the financial instrument is possible.
Regular divergence is the traditional understanding of divergence when the price action makes higher highs or lower lows while the oscillating indicator does not—indicating a weakness in the price action and suggesting that the price trend could be ending. In other words, regular divergence suggests that a probable trend reversal could occur through it does not indicate when this will happen. Thus, analysts often apply trend lines, chart patterns, and candlestick patterns to time the entry into the trade.
Regular Divergence can be a positive and negative divergence (bullish or bearish divergence).
- Positive Divergence (Bullish Divergence) indicates that price could start moving higher soon. It occurs when the price is pushing lower, but a technical indicator is moving higher or showing bullish signals. Indicating a weakness in the downtrend as selling power is exhausting or buyers are emerging. When the oscillator fails to confirm the lower lows on the price action, it can start building higher lows, which is more significant or can develop double or triple bottoms.
- Negative Divergence (Bearish Divergence) occurs when the price is climbing higher, but technical indicator like ADXS, or MACD is moving lower or showing bearish signals, leading to lower prices in the future. Bearish divergence indicates a weakness in the uptrend as buying power is exhausting, and selling or profit taking increases. Like the bullish divergence, the leading oscillator can fail to confirm the higher highs on the price action by making lower highs or can develop double or triple tops.
Hidden divergence occurs when the oscillator creates a higher high of lower low while the price action does not. Hidden Divergence tends to occur during consolidation or corrections within an existing trend. It is indicating that there is still strength in the prevailing trend and that the trend will continue. In other words, hidden divergence is related to a continuation pattern.
Hidden divergence can be bullish or bearish, just like regular divergence.
- Bullish Hidden Divergence happens during a correction in an uptrend when the oscillator makes a higher high, and price action does not as it is in a correction or consolidation stage. Bullish hidden divergence indicates that there is still strength in the uptrend. In that case, the correction is utterly profit-taking rather than the development of strong selling power and is thus unlikely to last long. Therefore, the uptrend is expected to continue.
- Bearish Hidden Divergence happens in a downtrend when the leading oscillator makes a lower low while the price action does not. As the downtrend is in the consolidation stage—indicating that the selling has not decreased and the downtrend is still strong. Bearish Hidden Divergence is simply profit-taking rather than the emergence of strong buyers and is thus likely temporary, and the downtrend is more likely to be expected to proceed.
Like all technical analysis methods, traders should use various indicators and analysis methods to confirm a trend reversal before acting on divergence alone. Divergence will not be part of all price reversals; therefore, apply other risk management strategies or analysis to get the best from trading both regular- and hidden divergence.
Remember, when divergence does occur, it doesn’t mean the price will reverse, or a reversal will happen any time soon. Divergence can last an extended period, so running on it alone could mean substantial losses if the price doesn’t behave as expected, or risk management is not applied.
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