If you are looking for a relatively low risk strategy to sell close to the top of a trend or buy close to the bottom, exit long positions profitably or execute a profitable short, you should be seriously looking at divergence trading. Divergence is executed by combining price action with the movement of any indicator such as stochastic, RSI and so on. It can be used as a leading indicator and, if properly executed, can be consistently rewarding. In the process, you are also minimizing risk because you are buying near the top and selling near the bottom.
Price and momentum generally move in step, and, if the price action indicates a higher high or a lower low, your chosen oscillator should also be behaving likewise. However, if this is not happening, the price and your chosen oscillator are diverging and this is why the phenomenon is known as divergence. This is a clear sign that there is something going on in the market and that you could be looking at the end of a trend or a momentum reversal.
Regular divergence can be an indicator of a possible trend reversal. If the price is showing lower lows (LL), but the oscillator is showing higher lows (HL), this is regarded as regular bullish divergence. This is the normal situation when a down trend is coming to an end. After showing a second bottom, if the oscillator fails to register a new low, it is quite likely that the price will start to rise. On the other hand, if the price is showing a higher high but the oscillator is showing a lower high, the phenomenon is referred to as regular bearish divergence. You can expect to see this when an uptrend is ending and, if the oscillator shows a lower high after the price has registered a second high, you should expect to see a price reversal and prices should begin to drop. The illustration below demonstrates a regular bullish divergence.
As you can see from the above diagram, the regular divergence technique is most appropriate when you are looking for tops and bottoms and points where prices could reverse. The oscillators indicate that market momentum is starting to shift and even though prices are moving in a particular direction, there is a good chance that this movement is not going to be sustainable.
Divergences can be used not only to spot potential reversals in the trend but also possible continuations. Since you would normally be trading with the trend, the sign that the trend is going to continue should be good news for you. Hidden bullish divergence shows up when the price is registering a higher low but the oscillator is registering a lower low. This can normally be seen in the course of an uptrend and, if the price is registering a higher low, see if the oscillator is following suit. If it does not, you are looking at hidden bullish divergence. Along the same lines, you can see hidden bearish divergence when the price shows a lower high but the oscillator is showing a higher high. This normally happens during a downtrend and shows that there is a good chance that the downward trend will continue. The illustration below shows an example of a hidden bullish divergence.
Finally let us look at how to actually trade on divergence by looking at some actual historical price movements for regular divergence. Take a look at the diagram below
It is clear that the price is in a downtrend but this could be coming to an end because the price is showing a divergence from the stochastic. Could this signal the end of the downtrend and a reversal? If you acted on this conviction, you would have made a lot of money if you bought because the price subsequently broke through the trend line and continued upward. Because you bought near the bottom, you would have maximized the profit on your position.
Let us now consider an example of hidden divergence by looking at the example below
You can clearly see the downtrend and the next question is what you should do with this hidden bearish divergence. Of course, you could always do nothing and then kick yourself for having missed a golden opportunity. As things turned out, the price reversed from the trend and went down much further. If you have correctly interpreted this as a continuation of the downtrend, you would have been laughing all the way to the bank.
Some basics in trading divergence
Divergence only happens in four specific situations and you should not go looking for your indicators in situations where divergence does not exist. You should also remember that divergence does not happen in markets that are ranging. If two new highs are established, your lines should only connect the tops and similarly if two new lows are established, your lines should only connect the bottoms. Only then should you look at your indicators to analyze price movements. Don’t forget to draw lines connecting tops or bottoms on your indicators as well. If you spot a divergence but the price has already reversed, forget about it and concentrate on your next trade.