What Is a Divergence in Trading and How to Spot It?

Technical analysis offers various tools to interpret market movements and anticipate potential shifts in asset prices. Among these tools, divergence stands out as a concept indicating a disagreement between an asset’s price action and a technical indicator. This discrepancy provides valuable insights into underlying market momentum, helping traders gauge trend strength and identify unsustainable price movements. It serves as a warning signal that the momentum supporting a price trend might be weakening or strengthening, even before a change is reflected in the price itself.

Understanding Divergence

Divergence occurs when an asset’s price moves in one direction while a related technical indicator, typically a momentum oscillator, moves in the opposite direction. For example, if an asset’s price makes new higher highs, but a momentum indicator simultaneously makes lower highs, this indicates divergence. This opposing movement is significant as it suggests a weakening of the underlying momentum driving the price trend. Normally, price and momentum indicators are expected to move in sync. When this alignment breaks, it highlights a discrepancy that can signal a potential change in market sentiment, offering early warnings about shifts in market momentum.

Types of Divergence

Divergence can manifest in various forms, each signaling different potential outcomes for price action. These categories are broadly divided into regular divergence and hidden divergence, both of which can be either bullish or bearish.

Regular Divergence

Regular divergence typically signals a potential trend reversal.

Regular Bullish Divergence occurs when the price of an asset makes a lower low, but the indicator forms a higher low. This pattern suggests that despite the price falling, the selling pressure is weakening, and the downward momentum is fading. It often appears at the end of a downtrend, implying that a potential upward reversal is on the horizon.

Conversely, Regular Bearish Divergence happens when the price makes a higher high, but the indicator forms a lower high. This suggests that the buying pressure is diminishing, and the upward momentum is weakening, even as the price continues to rise. This pattern typically occurs during an uptrend, signaling that a downward reversal may be imminent.

Hidden Divergence

Hidden divergence, unlike regular divergence, often suggests a continuation of the existing trend rather than a reversal.

Hidden Bullish Divergence is observed when the price makes a higher low, but the indicator forms a lower low. This specific pattern typically appears within an existing uptrend. It suggests that despite a brief dip in price, the underlying bullish momentum remains strong, signaling that the uptrend is likely to continue.

Similarly, Hidden Bearish Divergence occurs when the price makes a lower high, but the indicator forms a higher high. This pattern is found within a downtrend. It indicates that even though the price had a temporary bounce, the bearish momentum is still dominant, and the downtrend is likely to persist.

Indicators for Identifying Divergence

Identifying divergence in trading charts involves the careful observation of price action alongside specific technical indicators. Momentum oscillators are commonly used for this purpose, as they measure the speed and change of price movements, making discrepancies between price and momentum more apparent. The Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), and Stochastic Oscillators are among the most popular tools for spotting these patterns.

The Relative Strength Index (RSI) is an oscillator that ranges from 0 to 100, traditionally indicating overbought conditions above 70 and oversold conditions below 30. To spot RSI divergence, traders visually compare the peaks and troughs of the RSI line with the corresponding peaks and troughs in the asset’s price. For instance, if the price forms a lower low but the RSI forms a higher low, this indicates a bullish divergence. Conversely, a bearish divergence is present if the price makes a higher high while the RSI forms a lower high.

The Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that illustrates the relationship between two moving averages of an asset’s price. It consists of the MACD line, a signal line, and a histogram. Divergence on the MACD is identified by comparing the highs and lows of the MACD line or histogram to those of the price. A bullish MACD divergence occurs when the price records lower lows, but the MACD forms higher lows. A bearish MACD divergence is seen when the price makes higher highs, but the MACD forms lower highs.

The Stochastic Oscillator is another momentum indicator that compares a security’s closing price to its price range over a given period, typically 14 periods. It is composed of two lines, %K and %D, which fluctuate between 0 and 100. To identify stochastic divergence, traders look for instances where the price makes new highs or lows, but the stochastic oscillator does not follow suit. A bullish divergence emerges when the price forms lower lows while the stochastic oscillator forms higher lows. Conversely, a bearish divergence appears when the price forms higher highs while the stochastic oscillator forms lower highs.

Interpreting Divergence Signals

Once identified, divergence signals provide analytical insights into potential future price action, serving as a warning rather than a definitive prediction. Regular divergence indicates a potential trend reversal, suggesting that the momentum supporting the current trend is weakening. For instance, a regular bullish divergence signals diminishing selling pressure and a potential upturn, while a regular bearish divergence implies fading buying momentum and a possible downtrend.

In contrast, hidden divergence often implies a continuation of the existing trend after a temporary pause. A hidden bullish divergence suggests the underlying uptrend remains strong despite a minor price dip, indicating it is likely to resume. Similarly, a hidden bearish divergence indicates that a downtrend is still robust and likely to continue after a brief counter-trend move. These signals suggest a weakening or strengthening of momentum, which can precede a shift in price direction. However, these signals are not guarantees and should be used in conjunction with other technical analysis tools for confirmation. Traders often combine divergence analysis with other technical indicators or chart patterns to increase the reliability of their signals.