Trading Divergences, Regular and Hidden, Rules of Divergences Trading

Understanding the Basics of Trading Divergences

The market is all about uncertainties and finding ways to tame such uncertainties. Divergence trading is one of those tools that help you take a buy trade near the bottomed out prices, or close your trade once the trend reaches the high point. You could always stay ahead of time by applying divergence trading.

Divergence trading calls for comparing the movement of an indicator with the price action. It is immaterial which indicator you apply; it can be anything from RSI to MACH and stochastic. Divergences can thus be used as a leading indicator. After some initial understanding and practice, it becomes easy to spot trading divergences on the chart. Divergences are significant because they help you enter a trade when prices have bottomed out or take a sell call when the prices are close to the top. This means that you are taking trades on a favorable risk-reward ratio.

In simple words, divergence is all about lower lows and higher highs. Momentum and price cannot be separated at any point of trading. If you notice price making higher highs, then have a look at the oscillator too. It also would be trading in the same way. The same thing applies to reverse trade. In case the action of price and the oscillator are not the same, that is they are diverging, then we call it as divergence. Divergence trading is of utmost importance in identifying a reversal in momentum or knowing a weakening trend. Even it can help you to gauge if the trend is going to continue for some more time. The two types of divergence trading are regular and hidden.

Regular Divergence

What Does Regular Divergence Indicate?

You can use the regular divergence to identify a possible indication for a trend reversal. Again regular divergences can either be bearish or bullish. It is a regular bullish divergence when the price is registering lower lows, but at the same, the oscillator is registering higher lows. This kind of price pattern is usually noted when a downtrend is about to end. In case the oscillator cannot register a new low after making a second bottom, it is considered that this is the reversal point. The price will rise, as momentum and price are usually expected to trend in line.

Below image depicts regular bullish divergence:

Another type of regular divergence is a regular bearish divergence. In this scenario, the price is registering a higher high; however, the oscillator is making a lower high. This case makes for regular bearish divergence, and it is seen in an uptrend. When the oscillator registers a lower high after price registers the second high, it is an indication that price will reverse and decline. The image below indicates the same trend:

In the image shown below, we see that price reverses after making the second top.

The regular divergence can be best applied when you are trying to initiate a trade around tops or bottoms. You can identify the area where the price will halt and then begin with reverse trade. The oscillators notify that momentum is beginning to shift and although the price has recorded a lower low (or higher high), there is a probability that it won’t be continued.

How To Trade Divergences

Divergence Trading

Divergence is the movement of the price chart and the oscillator used in analyzing the market in different directions. Here are some examples to help you put your divergence skills to work and reap from the markets.

Trading a regular divergence

Lets first consider the USD/CHF  daily chart below to understand how regular divergence works.

The dipping trend line indicates that the USD/CHF is on a downward trend, although there is a possibility that the downward trend is ending. The stochastic indicator shows a higher low while the price shows lower lows. There is uncertainty here on whether the reversal is ending or whether it is right to buy the sucker.

If you agree that it is time to buy, then you will reap because you would have previously been in short regarding pip winnings. If there is a divergence in price action relative to the stochastic, then that is a good sign for buying. The price broke the dipping trend line and established a new increasing trend.

Therefore buying at the bottom will enable you to make couple pips with the pair like to shoot higher in the coming months.  Always look for indications of a reversal which will confirm that the trend is ending.

Trading hidden divergence

When trading a hidden convergence, there is a downward trend for the pair with the price forming at a lower high while the stochastic registers a higher high. Consider the chart below.

The chart demonstrates a hidden bearish divergence and to get back in the trend all you have to do is watch from sidelines and wait.

How to Avoid Entering Too Early When Trading Divergences

Avoiding Early Entry In Divergence Trading

Having divergences in your trading toolbox can prove to be very resourceful by helping you in situations when you are likely to enter too early without waiting for further confirmation.  The downside of entering too early is that you will end up being stopped out and as a result start racking up losses.

Wait for crossover indicator

The general rule of avoiding early entry is waiting for the crossover indicator. It helps in establishing the potential change in momentum from both buying and selling.

For instance, in the above chart, the pair demonstrated lower higher when the stochastic had already established higher highs.  This is a form of bearish divergence that is tempting to short immediately.

However, if you are patient and hold on for the stochastic to have a downward crossover, you will be better placed since you will have confirmation on the downward direction the pair is taking.

However, from the chart above, the stochastic made a crossover after a few candles implying that playing a bearish divergence would be something pip-static.  The secret is to wait.

Draw trend lines on indicators

Drawing trend lines on both indicators is also another trick that can help you.  The trick is useful when considering breaks from trend or seeking reversals. When the price is relating to the trend line, draw a similar trend line on the indicator. It is apparent that the indicator also respects the trend line.

In the event, the price action and the oscillator breaks their trend lines respectively, then it is a sign of a change in power to sellers from buyers and vice versa, indicating a changing trend.

9 Rules for Trading Divergences

Divergence Trading Rules

When considering potential divergences, there are trading divergence rules that you should observe. The rules are very important, and they can help in making good trading decisions, and if you ignore them, you risk going broke.

Be on the clear

Divergence can only exist once the price has formed either a double top or double bottom or a lower low than a prior low or a higher high than a prior high. Look for an indicator only if any of the price scenarios are met if not then you are not trading a divergence.

Drawing lines on successive highs and lows

There are only four scenarios in divergences, which are flat high, a higher high, flat low, and lower low. Try drawing a backward line from the current low or high to the previous successive low or high. If there are dips between major lows or highs, then you should ignore it.

Connect TOPS and BOTTOMS

When two lows are established, then you connect bottoms, and if two successive highs are made then you should connect Tops as shown in the chart.

Focus on the price

After connecting either the two bottoms or the two tops using a trend line, you should consider comparing the indicator to the price action. Regardless of the indicator you employ always remember it’s a comparison of BOTTOMS or TOPS.

Be smart like Pip Diddy

Once you draw a line for two highs, always remember to draw one connecting indicator highs. The same is applicable for lows. Equally, when you draw a line to connect lows on the price, you have to match them by drawing one connecting the lows on the indicator. The chart below demonstrates the concept.

Maintain the line

The identified lows or highs on the indicator need to be in line vertically relative to the price highs. They have to match, as demonstrated in the chart.

Follow the slopes

Divergence can only exist if there is a difference between the slopes of the line that connects indicator tops or bottoms and the slope of the line that connect6s price action tops. The slope can either be Flat, Ascending, or Flat.

If you miss an opportunity wait for the next

You may see divergence, but when the prices have reversed and become unidirectional for quite some time. In such a situation n divergence is said to have played out and you have to be patient until the formation of the next swing low/high and then begin your divergence.

Consider divergence on longer time frames

Divergence clues are accurate when longer time frames are considered as there are less false signs. You will have fewer trades. However, if the trade is structured well, you will reap exceptionally. Shorter time frames divergences are the most common, but they are not that reliable.

It’s advisable to go for a 1-hour or more divergence charts rather than the 15-minutes or less than most traders prefer. Because of the much activity associated, it is better to stay away.

Divergence Cheat Sheet

Divergence Reference Sheet

Divergences are normally of two types, which are the regular divergence and the hidden divergence. There is either a bearish bias or a bullish bias for each of the divergence types. This cheat sheet will help in spotting hidden or regular divergence seamlessly.

This shouldn’t be much to remember as you can grasp the concepts easily. You can note the concepts down so that you can refer to them when trading so that you don’t mix up lower lows, high lows, higher highs, and lower highs. Don’t just make a wild guess when trading.

Wrap Up

What is Divergence?

Divergence in technical trading occurs when an indicator and price of an asset are moving in the opposite direction. A negative divergence comes into play when the price of a security is in an uptrend and an indicator, such as moving average convergence divergence or relative strength index, is heading downwards.

Negative divergence is also known as a regular bearish divergence. This occurs when a price is making higher highs, but the oscillator is making lower highs. When the price makes a second high, then the price is likely to make a lower high. If this was to happen, then the price of the security is likely to reverse and start dropping.

Positive divergence, on the other hand, occurs when the price is in a downtrend, but an underlying indicator starts to rise. A regular bullish divergence happens when the price of an asset is making lower lows, but an indicator, which could be an oscillator, is making higher lows. In case the oscillator fails to make a new low, then the price of an asset is likely to reverse and start rising.

Divergence is mostly used to pick tops and bottoms in the market. They provide an early indication that the price of an asset is likely to reverse. The oscillators in this case act as a warning sign indicating that momentum is starting to shift even if the price has made higher high in case of bullish market or lower low in case of a bear market.

Understanding divergence is important as it helps a trader recognize and respond to changes in price action. Divergence indicates that something is about to change.