Since trends are made up of numerous price swings, momentum is crucial in determining the strength of a trend. As a result, it’s crucial to recognise when a trend is slowing down and making trading divergences.
Although a decline in momentum does not always indicate a trend reversal, it does indicate that something is shifting, and the trend may consolidate or reverse.
The magnitude and direction of the price are referred to as price momentum. Trading professionals can better understand price momentum by comparing price swings.
Divergence trading can sometimes be intimidating for beginners. Not only do you need to understand the main categories of divergences, but they do not always indicate the expected result.
Making a trading decision based solely on divergences is never a wise one. Although strong, divergences should only be used as a confirmation tool. What, however, are divergences?
Here, we’ll examine how to assess price momentum and demonstrate what trading divergence in momentum can reveal about a trend’s direction.
What are Trading Divergences?
Simply put, divergences occur when a price moves in one direction while another indicator—typically an oscillating indicator—moves in a different direction.
In essence, you have a divergence if you observe the price rising and setting new higher highs while the oscillator is setting new lower lows. Here are some illustrations of the four most common types of divergences.
Types of Divergences
Below are different types of trading divergences:
1. Bullish Divergences
A bullish divergence, also known as a regular bullish divergence, is the first thing we will notice. For this example, the oscillator will be the RSI.
You’ll notice that there are recurring, similar patterns that are associated with divergences when you trade with them. Near the end of a downtrend is where you’ll typically find this in a typical bullish divergence.
According to divergence theory, there is a good chance that the price will reverse. Observe how the RSI has made higher lows while prices have made lower lows. Price behaved in the opposite way, testing a swing high and then the previous swing low before continuing to rise, which resulted in another, more pronounced regular bullish divergence.
2. Bearish Divergences
Let’s now look at a typical bearish divergence.
In essence, a trade with divergences that are bearish will indicate movement to the downside. Similar to how we see it form a regular bullish divergence pattern near the end of a downtrend, we see it form a regular bearish divergence pattern at the end of an uptrend.
The price has made a higher high (on this chart, it made a significant leap), but on the RSI oscillator, we have lower highs, which is the divergence that we observe. According to divergence theory, there is a good chance that the price will reverse to the downside.
As can be seen, a trade with divergence on the bearish bias led to a decline in prices and the beginning of a downward trend.
The following two divergences are examples of hidden divergences.
Hidden divergences, however, merely indicate a divergence within a trend. Hidden divergence is a sign that the trend will continue, whereas regular divergences indicate a reversal of trending price action in a trade.
3. Bullish Hidden Divergence
Take note of how we are in an uptrend in this instance of a hidden bullish divergence. In addition, we keep making higher lows while the RSI oscillator keeps making lower lows.
There is a high likelihood that the price will stay in the uptrend in a trade with hidden bullish divergence signals. Keep an eye out for the higher low that was formed at the arrow’s point because price action with candlestick patterns can confirm the continuation of the trend.
The bottom of this hidden bullish divergence looks like a tweezer. And as we can see, the price did rise further.
4. Bearish Hidden Divergence
Usually the RSI oscillator has made higher highs while prices have continued to decline and have formed lower highs. This phenomenon is referred to as a hidden bearish divergence.
According to divergence theory, there is a good chance that the downward trend will continue. Once more, a hidden bearish divergence pattern indicates that the downward trend is still in place.
We created this head and shoulders pattern solely to demonstrate how Price responded to the emergence of this well-known pattern and how the lower high failed to push past the right shoulder. That served as yet another confirmatory indicator of trend persistence.
How to Trade with Divergences?
How does one trade with divergences now that we have identified four typical types of divergences?
We used the RSI oscillator in the aforementioned four examples. It is most likely the most typical oscillator type used to find divergences. However, there are many oscillators, and each has advantages over the others: Stochastics, RSI, Chaikin Money Flow, Awesome Oscillator, Ultimate Oscillator, etc.
There are simply a lot of oscillators available for use. The RSI and Stochastics oscillators are the most widely used oscillators for divergences.
You can also join our course Masterclass on Short-term Momentum Trading
Trading Divergence Example with RSI Stochastics
The Stochastic RSI is basically an indicator of an indicator. Where Stochastics measure the momentum of price and RSI measures the strength of the price movement, Stochastic RSI measures the momentum of the RSI.
This is what is known as a typical bearish divergence. With the stochastic RSI, you would have seen that much more clearly than you would have with the RSI or stochastics.
As we can see from the above daily chart of JSW Steel, one can easily trade by analyzing bullish and bearish divergences.
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