A divergence between the price action of an asset and an oscillator (such as the Awesome Oscillator, MACD or Relative Strength Index) can identify high probability trading setups.
What is a Divergence?
Price and momentum should move hand-in-hand, and if they don’t, then it may suggest that there is an opportunity to trade a divergence. However, traders must be careful not to enter a trade too early or without confirmation, as not every divergence will be a profitable setup.
It is important to align the price and oscillator when drawing trend lines and plotting divergences. For instance, the low in the price should correspond with a high/low in the oscillator. Also, to prevent fake signals, divergences should be combined with other technical indicators and used as confirmation of a reversal or continuation of a trend.
There are four types of divergence:
- Regular Bearish Divergence
- Regular Bullish Divergence
- Bearish Hidden Divergence
- Bullish Hidden Divergence
A regular divergence often indicates a potential reversal, and can be either bearish or bullish. Regular divergences generally work best on longer timeframes, since the reversal will occur over a longer period of time giving more time for the trader to take advantage of the divergence.
Divergences on shorter timeframes may be very short lived and the trader may miss the move.
Regular Bearish Divergence
A Regular Bearish Divergence occurs when the price is making a higher high but the oscillator is displaying a lower high. This type of divergence is usually found at the end of an uptrend.
An example for bitcoin is shown below. As the price posted a higher high, the Relative Strength Index (RSI) displayed a lower high as shown by the trend lines on the chart. With a regular bearish divergence, we may want to wait for the RSI to move out of the overbought zone before entering a short position.
Therefore, the short position would have been opened at the opening or closing price of the first candle associated with an RSI reading below 70, i.e., at $10,750 or $10,640.
As the chart above shows, the RSI continued to fall and eventually reached oversold territory (less than 30), with the price of bitcoin bottoming around $10,474 a few days later and then reaching another low of $10,389.
Regular Bullish Divergence
Regular Bullish Divergence occurs when the price is making a lower low, but the oscillator posts a higher low. This type of divergence usually occurs at the end of a downtrend.
The chart below shows an example of a Regular Bullish Divergence. The price of bitcoin was in a downward trend, making lower lows over time, however, the RSI made higher lows when bitcoin was trading beneath $10,000. Therefore, once the second trough of the RSI was complete, the trader could have entered a long trade around $10,014-$10,055.
Following the Regular Bullish Divergence, the price action started to establish an uptrend. The RSI can help to determine when to exit the long position, i.e., when the Index is above 70. We can see that the RSI suggested to exit the long position between $10,360 and $10,460.
While regular divergences highlight potential reversals, hidden divergences point to a continuation of the prevailing trend.
Hidden divergences work best with higher timeframes, since trend continuation on lower timeframes may play out too quickly to act on them.
Hidden Bearish Divergence
Hidden Bearish Divergence is found during a downtrend, occurring when the price is making a lower high but the oscillator is displaying a higher high.
The chart above shows hidden bearish divergence for bitcoin. After falling from the $12,000 level, the price exhibited two lower highs at $10,958 and at $10,775 which aligned with higher highs in the RSI.
After the higher high in the RSI, the oscillator dipped, and the price followed falling from the $10,000 zone to lows near $7,700. As new lows were established, the RSI fell into oversold territory which indicates that the trader should start thinking about exiting their position.
Hidden Bullish Divergence
Hidden Bullish Divergence is found in an uptrend, occurring when the price is making a higher low while the oscillator establishes a lower low.
The chart above shows a hidden bullish divergence in the price of bitcoin. In early June, the price displayed higher lows at $7,427 and $7,509 respectively, while the RSI exhibited lower lows.
As the second low of the RSI was posted, a trader could have taken advantage of the hidden bullish divergence by buying on the next day’s open at $7,635. Alternatively, a more careful strategy would have been to wait for a bullish candle following the hidden bullish divergence and enter a long position on the close and/or when the RSI moves back above 50.
If the trader waited for confirmation, they would have entered at the closing price of the next day’s candlestick just above $8,000 (since the next day was bullish and the RSI moved up to 53.46). The RSI continued to trend higher, which would have been a sign to stay in the long position. The RSI entered overbought territory as the price broke above $10,000, which should caution the trader to start looking for a good exit point for their long position.
In summary, divergences can identify high probability setups but be careful using them on lower timeframes as divergences tend to work better with higher timeframes (such as the 4-hour or daily chart).