Divergence
Divergence is a concept that can allow a trader to see a possible reversal in the direction of price ahead of time.
When you see a divergence, it is not a definite indication that the market will change, or that as soon as a divergence is seen, a trader should enter a counter-trend trade. It does, however, allow a trader to see that the current market conditions could be changing and they should start looking for possible entries in the opposite direction to the current trend. The higher the time frame the stronger the likelihood that a reversal may occur.
What is divergence and how to spot it
Usually, when using indicators, you would look for specific signals — for example, when the stochastic indicator crosses the 20 or 80 line, or for the MACD lines to cross over.
Generally, an indicator will move in conjunction with the price — if the price is making higher highs, then the indicator will also make higher highs, as observed by the chart below.
- Higher highs on the price and higher highs on the indicator
However, a divergence takes place when the indicator moves out of sync with the price action over a period of time. The length of the time is unimportant, just enough to make the comparison.
To find a divergence, first, see which way the market is trading. In the chart below, price is making a series of lower lows and lower highs denoting a downtrend. The indicator, however, is not making lower lows; it has made a higher low.
- Lower lows on the price chart
- Higher lows on indicator chart
- Soon after the divergence has taken place, price enters into a new direction
As you can see in the chart, a divergence has taken place between the price action and the indicator. The price has made lower lows, but the MACD histogram has made higher lows. Soon after, the downtrend starts to reverse to the upside.
It takes practice to spot a divergence. However, once you are accustomed to finding them, they can be a useful tool to spot upcoming trend changes.
Key points to remember:
- The higher the time frame, the longer it may take for the trend reversal to actually happen.
- Divergence can be used on a lower time frame, but it pays to be a little more cautious. Sometimes by the time you spot a divergence on a lower time frame, the reversal may have already happened.
Which indicators can be used to find divergence?
Common indicators are the stochastic indicator, the MACD and the OsMA. However, almost all indicators can be used to find divergence.
The chart below shows an example of divergence being spotted using the stochastic indicator.
- Price shows higher highs
- Stochastic shows lower highs
- Price direction reverses
The chart below shows an example of divergence being spotted using the OsMA indicator.
- Price shows higher highs
- OsMA shows lower highs
- Price direction reverses
Using divergence for trading
There are a number of ways you can use divergence for trading. However, you should remember that divergence is a concept that should be used in conjunction with a strategy. That means you still need to define your entry point, your stop loss and your profit target. Divergence can be helpful in preparing you to get into a new trend direction early on.
The following table gives you an overview of what kind of divergence is taking place, the behaviour of the price action and indicator, and what kind of a trade you should look for.
Below are a few examples of how you can apply divergence in your trading decisions.
Trend line break out
Using a trend line as shown in the chart below, you can find an entry by first finding a divergence and then entering into a position once the price action breaks the trend line. This can be used in conjunction with multiple time frame analysis or on a single time frame.
- Price action shows lower lows
- MACD shows higher lows
- Entry after the breakout through the trend line
Multiple time frame analysis
Divergence can be combined with multiple time frame analysis. If you are using a higher time frame to identify the direction, then a divergence can help you find a change in the overall trend. It is then possible to go to a lower time frame and find an entry using a specific method, such as a trend line breakout.
In the chart below, a higher time frame is used to determine the market direction; the indicator shows a divergence, thus indicating a price reversal.
- Price shows higher highs
- OsMA shows lower highs
- Price direction reverses
You can then move to a lower time frame to find possible entries, as shown in the chart below.
- Possible entries after the trend line is broken
Summary
So far, you have learned that ...
- ... divergence is a way of identifying a possible change in market direction ahead of time.
- ... it can be a powerful tool to enter into a counter-trend trade.
- ... there are two types of divergence: bearish, shown as higher highs on the price chart and lower highs on the indicator; and bullish, shown as lower lows on the price chart and higher lows on the indicator.
- ... on a higher time frame it may take longer for the reversal to happen.
- ... the higher the time frame, the more reliable the signal is.
- ... to find entries, divergence can be combined with multiple time frame analysis or a trend line break.
