What is divergence and why is it important for traders

Divergence (Divergence) is one of the long-standing technical analysis tools used in trading. It shows a conflict between price and indicator (Indicator) when both are not moving in the same direction. This signal often appears when a trend is about to change, but there are other types that confirm trend continuation as well. This article will present ways to understand and apply divergence to maximize trading benefits.

Basic Understanding of Divergence

Divergence is a situation where the price moves in one direction, but the technical indicator does not confirm the same. When this occurs, price and indicator are out of sync, indicating that the current trend may be at risk or a change is imminent.

Understanding divergence requires knowing what it indicates. It does not mean the indicator is useless, but rather it serves as a “warning” signal to traders that something is changing. In such situations, divergence can tell us 4 possible scenarios:

Scenario 1: Price drops sharply, but the indicator does not confirm the decline and instead shows bullish signals. This is called Bullish Divergence, which may indicate that the decline is about to stop and the price will reverse upward.

Scenario 2: Price rises sharply, but the indicator does not confirm the increase and instead shows bearish signals. This is called Bearish Divergence, which may suggest that the upward move is about to pause and the price will reverse downward.

Scenarios 3 and 4: Price fluctuates weakly, but the indicator still shows strong signals. This is called Hidden Divergence, indicating that the current trend has not ended and will continue.

Popular Indicators for Detecting Divergence

When it comes to indicators, traders often use those in the Oscillator group or those measuring momentum, such as:

MACD - a trend-following tool based on moving averages

MACD uses only 2 moving average lines. When MACD is positive and increasing steadily, it indicates bullish momentum. Conversely, when MACD is negative and decreasing, it indicates bearish momentum. When the price makes a new high but MACD does not follow or moves in the opposite direction, that’s a divergence signal.

RSI - an overbought/oversold momentum indicator

RSI is a popular indicator for predicting turning points. When RSI exceeds 70, it indicates overbought conditions, and the price may decline. When RSI drops below 30, it indicates oversold conditions, and the price may rebound. Divergence signals with RSI are often clear in these two zones.

Williams %R - a price closing level indicator within the price range

Williams %R works similarly to RSI, with values from 0-100. When %R exceeds 80, it indicates overbought; below 20, oversold. Divergence in these zones can be good signals for trend reversal.

Regular Divergence - Trend Reversal Signal

Regular Divergence occurs when the price trend is strong, but the indicator does not confirm that strength. This signals that the trend is weakening and a reversal may be near.

Bullish Divergence - Reversal Up Signal

Bullish Divergence often occurs after a strong downtrend. When the price makes new lows (Lower Low) repeatedly, but RSI or MACD do not make new lows and instead start to rise, this is Bullish Divergence, indicating selling pressure is weakening and a reversal upward may happen.

How to trade Bullish Divergence:

1. Look for price patterns showing Lower Low or Double Bottom at the end of a downtrend.
2. Observe indicators, especially when entering oversold zones (Oversold) and not making lower lows.
3. When the price shows reversal signals, such as a green candle closing or price returning to the moving average, enter buy trades.

Bearish Divergence - Reversal Down Signal

Bearish Divergence occurs after a strong uptrend. When the price makes new highs (Higher High) repeatedly, but RSI or MACD do not confirm the rise and instead start to decline, this is Bearish Divergence, indicating buying momentum is weakening and a reversal downward may occur.

How to trade Bearish Divergence:

1. Look for price patterns showing Higher High or Double Top at the end of an uptrend.
2. Observe indicators, especially when entering overbought zones (Overbought) and not making higher highs.
3. When the price shows reversal signals, such as a red candle closing or price returning to the moving average, enter sell trades.

Hidden Divergence - Trend Continuation Signal

Hidden Divergence is often overlooked but is very important. It occurs when the price shows weak signals, but the indicator continues to show trend strength. This indicates that the current trend is not over and will resume.

Hidden Bullish Divergence - Indicates ongoing upward movement

Hidden Bullish Divergence occurs during an uptrend. When the price retraces with a Higher Low (Higher Low), but RSI or MACD still signals strong bullish momentum and does not make a Lower Low (Lower Low), it suggests the correction is just a pause, and the uptrend will continue.

How to trade Hidden Bullish Divergence:

1. Look for price patterns showing Higher Low in an uptrend.
2. Confirm that indicators are not in oversold zones and still show strength.
3. When the price breaks above the retracement level with a green candle, enter buy trades.

Hidden Bearish Divergence - Indicates ongoing downward movement

Hidden Bearish Divergence occurs during a downtrend. When the price rallies with a Lower High (Lower High), but RSI or MACD still signals strong bearish momentum and does not make a Higher High (Higher High), it suggests the correction is just a pause, and the downtrend will resume.

How to trade Hidden Bearish Divergence:

1. Look for price patterns showing Lower High in a downtrend.
2. Confirm indicators are not in overbought zones and still show strength.
3. When the price breaks below the rally’s support with a red candle, enter sell trades.

Real Market Examples of Divergence Trading

Case of Regular Bullish Divergence

Imagine BTC is in a downtrend, dropping from $50,000 to $40,000 over some time. RSI drops to 25, entering oversold territory.

Then, the price rises slightly and drops again to $39,000 (Lower Low), but RSI does not go below 25 and starts to rise. This is a Regular Bullish Divergence indicating weakening selling pressure.

When a long green candle closes, traders can enter a buy at $39,000 with a stop loss at $38,500 and target profit at $42,000.

( Case of Hidden Bullish Divergence

Suppose ETH is in an uptrend at $2,000, retracing down to around $1,900. RSI is around 50 )mid### and not in oversold territory.

When the price hits $1,900 (Higher Low) (previous low was $1,850), and RSI remains at 45 (not making Lower Low), this indicates Hidden Bullish Divergence, suggesting the correction is just a pause.

When the price breaks above $1,950 with a large green candle, traders can go long at $1,950 with a stop loss at $1,920 and target at $2,100.

Cautions When Trading with Divergence

Divergence is a useful tool but not 100% accurate. Often, divergence appears multiple times before the price moves as expected.

Caution 1: Divergence can occur several times before a trend change. Do not enter trades immediately; wait for additional confirmation, such as breaking key levels or clear candlestick patterns.

Caution 2: “Trend is King” – sometimes, even with divergence signals, the trend continues because the underlying momentum remains strong.

Caution 3: Combine divergence with other analysis tools, such as moving averages, support/resistance, or candlestick patterns, to improve reliability.

Caution 4: Always set stop losses and manage risk properly, even if signals look promising.

Summary

Divergence is a valuable analysis tool that helps traders understand the strength or weakness of the current trend. Once you understand the difference between Regular Divergence and Hidden Divergence, you can use it to predict trend reversals or confirm trend continuation.

However, divergence should be used alongside other tools and proper risk management to make trading more effective and reduce risks. With practice and deep understanding, divergence alone can become a powerful tool to grow your investment portfolio steadily.