Divergence is a very useful tool to help traders spot trend reversals or continuation patterns. Being able to spot these types of patterns is a massive advantage as they will help you to identify new trading opportunities and give you an idea of future price action.
In this guide, we’re going to cover everything you need to know about divergence, including what it is, the different types and how to spot & use them effectively.
Ready? Let’s get started.
Before we get started, it's important to first understand what divergence is and how we can use it in our day-to-day trading strategies.
Divergence as a general term in trading can be defined as when an oscillator or momentum indicator does not confirm the direction of the current price movement. This can be either bullish or bearish.
It occurs when price makes a higher high or lower low and the momentum indicator or oscillator will do the opposite (make a higher high if price makes a lower low and vice versa).
There are two types of divergence:
Within these types, there an additional two subsets:
So, all in all, here are four possible types of divergence:
To complicate matters even further, you can also have ‘mild' divergence, where a disparity exists but it is not as strong.
The main difference between Hidden Divergence and Regular Divergence is that Hidden Divergence is a sign of trend continuation, whereas Regular Divergence is a sign of trend reversal.
Hidden divergence occurs when an oscillator or momentum indicator makes a higher high or lower low, but the price does not. It usually occurs during price consolidation or corrections and can be used as a continuation pattern or signal.
Divergence can be used to either spot the potential for a trend reversal, or if you are looking for hidden divergence, it can be used to spot a trend continuation.
Some of the indicators that can be used to spot divergence are:
Relative Strength Index (RSI)
A momentum oscillator, that gauges the direction and power behind price movements. It is most often used as a measure of being “overbought” or “oversold”. RSI calculates based on the candle close, which is why candle bodies are used rather than candle wicks to determine divergence.
On Balance Volume (OBV)
Another momentum indicator, it measures the flow of bullish and bearish volume to help draw a picture as to the strength or weakness of the underlying security. More or less, the OBV tells you if people are loading or dumping, and as with RSI, the OBV calculates based on candle close so we use candle bodies rather than wicks to determine divergence.
Bearish divergence is when the price of an asset reaches higher highs, but the momentum indicator or oscillator shows lower highs. The discrepancy between price action and the momentum indicator indicates that the momentum in the current price trend is slowing and we could see a fall in price about to occur soon.
Hidden bearish divergence occurs when the oscillator continues to make lower lows, but the price action does not, and instead begins to consolidate.
As mentioned previously, hidden divergence can be used as a continuation. So, it indicates that we could see price break to the downside to continue its current trend.
Here is an example of Bearish Hidden Divergence:
In the above example, we can see $XRP #Ripple on the 12-hour chart from back in July of 2019, with the price making a lower high while the RSI made a higher high.
Why is this a problem? If bulls can somehow manage to stop the bleeding, your RSI is already overbought and that will cut the run short. This was a clear sign of bearish continuation to come.
Here is a good example of bearish divergence with OBV:
In the above example, we have $ETH #Ethereum on the 12-hour chart from back in October of 2019, with the price working through a bearish continuation pattern.
As you can see, the price was making higher highs while the OBV was making lower highs, suggesting that the price was moving up without sufficient volume and a further bear correct was due.
Bullish divergence is the opposite of bearish divergence. Bullish divergence occurs when the price is creating lower lows, but the momentum indicator is showing higher lows, indicating a weakening of the trend and a potential reversal.
Again, it is the opposite of hidden bearish divergence. When price is in an uptrend and consolidates, not making any higher highs, but the oscillator continues to make higher highs, this is hidden bullish divergence.
It indicates that we may see an upside breakout and continuation of the bullish trend.
Here is an example of Hidden Bullish Divergence
In the above example from Bitcoin on the 4-hour chart back in early February, the price was putting in higher lows while the RSI cooled off, setting things up nicely for a new bull leg higher.
Below is a textbook example of bullish divergence with OBV:
Here, you can see Litecoin on the daily chart from back in December of 2019. The price was making lower lows while the OBV made higher lows. This suggested that people were loading the stock as it was falling, presaging a reversal.
As a general rule with any candle or chart signal or pattern, the longer the time frame the stronger the signal.
That means that you should be careful using bearish and bullish divergence on shorter time frames like 1-hour and 4-hour.
Divergence can be a great way of confirming trend reversals or continuations, and if used correctly, can form part of an extremely profitable strategy.