Divergence in Trading: A Guide to Using Contradictory Signals to Predict the Market

What is Divergence and Why Do Traders Care

Divergence is a conflicting signal that occurs when price movement and technical indicators do not point in the same direction. This may sound like a sign that indicators are unreliable, but in reality, Divergence is a highly valuable tool for market analysis.

When price and indicators do not confirm each other’s direction, this analysis can warn traders about potential market reversals, which can be categorized into four scenarios:

Situation 1 and 2: Regular Divergence - Reversal Signals

• When the price makes a Lower Low but the indicator does not confirm the decline, a Bullish Divergence occurs, indicating that the downtrend is weakening and the price may reverse upward.
• When the price makes a Higher High but the indicator does not confirm the rise, a Bearish Divergence occurs, indicating that the uptrend is weakening and the price may reverse downward.

Situation 3 and 4: Hidden Divergence - Trend Continuation Signals

• Hidden Bullish Divergence occurs when the price moves weakly but the indicator remains strong, suggesting the uptrend will continue.
• Hidden Bearish Divergence occurs when the price moves weakly but the indicator remains strong, suggesting the downtrend will continue.

Indicators Used by Traders to Detect Divergence

Most traders use oscillator group indicators to analyze Divergence because they can display the strength of price momentum.

1. MACD - An Effective Trend Tool

MACD uses two moving averages for calculation. When MACD is positive and increasing, it indicates a strong uptrend. When MACD is negative and decreasing, it indicates a strong downtrend. Divergence signals occur when the price creates new highs/lows but MACD does not confirm this movement.

2. RSI - Overbought and Oversold Indicator

RSI ranges from 0-100. An RSI above 70 indicates Overbought, and below 30 indicates Oversold. Divergence in these zones is a key point for predicting trend reversals.

( 3. Williams Percent Range )%R( - Another Effective Indicator %R shows Overbought when above 80 and Oversold when below 20. Divergence in these zones helps traders predict trend reversals.

Regular Divergence - Trend Reversal Signal

Regular Divergence is a conflicting signal that occurs at the end of a trend when the price moves strongly but the indicator does not confirm the same strength. This indicates that the trend is losing momentum and a reversal may occur.

) Bearish Divergence - Sell Signal Bearish Divergence occurs when the price makes a Higher High in an uptrend, but RSI or other indicators do not make a Higher High simultaneously. This suggests buying pressure is weakening, and the price may start to decline.

Trading example:

• The price has been making higher highs ###uptrend(, but RSI enters the Overbought zone above 70.
• The price makes a new High )Higher High###, but RSI forms a lower high, indicating bearish divergence.
• When a Shooting Star candlestick or reversal pattern appears, consider opening a short position (Short).
• Set a Stop Loss (Stop Loss) above the previous candlestick.

( Bullish Divergence - Buy Signal Bullish Divergence occurs when the price makes a Lower Low in a downtrend, but RSI or other indicators do not confirm the Lower Low. This suggests selling pressure is weakening, and the price may start to rise.

Trading example:

• The price has been making lower lows )downtrend(, but RSI enters the Oversold zone below 30.
• The price forms a new Low )Lower Low###, but RSI forms a higher low, indicating bullish divergence.
• When a long green candlestick or reversal pattern appears, consider opening a long position (Long).
• Set a Stop Loss below the previous candlestick.

Hidden Divergence - Trend Continuation Signal

Hidden Divergence is a different conflicting signal that occurs when the price moves weakly but the indicator remains strong. This indicates that the current trend has not ended and will continue.

( Hidden Bullish Divergence - Uptrend Continuation Occurs when the price makes a Higher Low )weak movement(, but RSI makes a Lower Low, indicating the uptrend will continue.

Trading strategy:

• Look for Higher Low formations when the price moves weakly in an uptrend.
• Confirm that RSI makes a Lower Low, proving Hidden Bullish Divergence.
• When the price breaks above resistance, enter a buy when the next candlestick opens.
• Set a Stop Loss at the previous candlestick’s low.
• Expect profits from the continuation of the uptrend.

) Hidden Bearish Divergence - Downtrend Continuation Occurs when the price makes a Lower High ###weak movement(, but RSI makes a Higher High, indicating the downtrend will continue.

Trading strategy:

• Look for Lower High formations when the price moves weakly in a downtrend.
• Confirm that RSI makes a Higher High, proving Hidden Bearish Divergence.
• When the price breaks below support, enter a sell when the price continues downward.
• Set a Stop Loss at the previous candlestick’s high.
• Expect profits from the continuation of the downtrend.

Factors to Consider When Using Divergence

Although Divergence is a useful tool, traders should be aware of some limitations:

1. Divergence can occur multiple times before the price actually reverses, so do not rely on a single signal.
2. Confirmation with other tools such as Support/Resistance, Price Patterns, or Volume is very important.
3. Always set a Stop Loss; even if Divergence appears, calculated risk management is fundamental.
4. Time Frame matters. Divergence on Daily charts is more reliable than on 4-Hour charts.

Summary

Divergence is a conflicting signal between price and indicator that helps traders better predict market changes. Regular Divergence indicates trend reversal, while Hidden Divergence suggests trend continuation. Understanding the differences and applying them correctly, along with good risk management, can significantly improve traders’ portfolio performance.

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Note: Derivatives instruments may cause you to lose all your funds. Please carefully study the risk disclosure documents.