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Lesson 9: Divergence Trading
Divergence trading is a powerful technique that helps traders identify potential market reversals before they become obvious on price charts. While most trading approaches focus on price action alone, divergence trading compares price movements with technical indicators to spot early warning signs of trend exhaustion. This method can help you find high-probability trading opportunities and improve your entry and exit timing.
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12 min read

In this lesson, we'll explore the concept of divergence, how to identify different types of divergences, and how to incorporate them into your trading strategy.

What Is Divergence?

Divergence occurs when the price movement of an asset doesn't match the movement of a technical indicator. This mismatch suggests that the current price trend may be weakening and could soon reverse.

In a healthy trend:

  • In an uptrend, both price and indicators make higher highs and higher lows
  • In a downtrend, both price and indicators make lower lows and lower highs

When divergence appears, this harmony breaks down, signaling potential trend exhaustion.

Types of Divergence

There are two main types of divergence: regular and hidden. Each type can be either bullish or bearish.

Regular Divergence

Regular divergence signals potential trend reversals and is the most commonly used type.

Regular Bullish Divergence:

  • Price makes lower lows
  • Indicator makes higher lows
  • Signals a potential upward reversal from a downtrend

For example, during a Bitcoin downtrend, the price might make a new lower low at $30,000 after previously reaching $35,000. However, the RSI might show a higher low compared to its previous reading. This suggests weakening downward momentum and a possible reversal.

Regular Bearish Divergence:

  • Price makes higher highs
  • Indicator makes lower highs
  • Signals a potential downward reversal from an uptrend

Hidden Divergence

Hidden divergence often signals a continuation of the existing trend after a pullback.

Hidden Bullish Divergence:

  • Price makes higher low (respecting the uptrend)
  • Indicator makes lower low
  • Signals potential continuation of the uptrend

Hidden Bearish Divergence:

  • Price makes lower high (respecting the downtrend)
  • Indicator makes higher high
  • Signals potential continuation of the downtrend

Best Indicators for Divergence Trading

While divergence can be spotted using many indicators, oscillators work best because they have definable ranges that make divergence easier to identify. The most popular indicators include:

  • RSI (Relative Strength Index): Measures the speed and change of price movements on a scale of 0-100. Divergence is clear when RSI fails to confirm new price extremes.
  • MACD (Moving Average Convergence Divergence): Shows the relationship between two moving averages. Divergence can be spotted on both the MACD line and histogram.
  • Stochastic Oscillator: Compares a closing price to its price range over a given period. Its bounded range (0-100) makes divergence patterns visually clear.

Other useful indicators include CCI (Commodity Channel Index), OBV (On-Balance Volume), and momentum oscillators.

How to Trade Using Divergence

Divergence alone shouldn't be your only reason to enter a trade. It works best when combined with other confirmation signals:

Entry Strategies

  1. Wait for confirmation: After spotting divergence, wait for a candlestick pattern (like a pin bar or engulfing pattern) or a break of a trendline before entering.

  2. Use support and resistance: Enter trades when price reacts to significant support or resistance levels along with divergence.

  3. Multiple timeframe approach: Confirm divergence on both higher and lower timeframes for stronger signals.

For example, if you spot a bullish divergence on a daily chart of S&P 500, you might wait for a bullish engulfing pattern to form before entering a long position. This combines the early warning from divergence with confirmation from price action.

Exit Strategies

  1. Target previous swing points: Use recent swing highs/lows as profit targets.

  2. Trail stops: After the trade moves in your favor, move your stop-loss to lock in profits.

  3. Watch for opposite divergence: Exit when the opposite type of divergence appears.

Best Practices for Divergence Trading

  1. Look for divergence after extended trends: Divergence is more reliable after a market has made a significant move and might be exhausted.
  2. Use multiple timeframes: Confirm divergence on both higher and lower timeframes for stronger signals.
  3. Combine with other analysis: Use support/resistance, trendlines, chart patterns, and candlestick patterns to confirm divergence signals.
  4. Pay attention to market context: Divergence works better in certain market conditions than others. Be especially cautious with divergence signals against strong trends.
  5. Use proper risk management: As with any trading strategy, always use stop-losses and position sizing appropriate for the volatility of the asset.

Key Takeaways

  • Divergence occurs when price movement doesn't match indicator movement
  • Regular divergence signals potential trend reversals
  • Hidden divergence signals potential trend continuations
  • Oscillators like RSI, MACD, and Stochastic work best for spotting divergence
  • Always wait for confirmation before trading divergence signals
  • Combine divergence with other technical analysis tools for better results
  • Be cautious of false signals, especially in strong trends

Next Steps

In our next lesson, we'll explore breakouts and fakeouts - critical concepts that help traders identify when price is breaking out of established patterns and how to distinguish genuine breakouts from false ones.