How to trade bullish and bearish divergences

What is a divergence?

A divergence is what happens when the price of an asset is moving in the opposite direction to a momentum indicator or oscillator. It is the opposite of a confirmation signal, which is when the indicator and price are moving in the same direction.

A divergence is often seen as a sign that the current market action is losing its momentum and weakening, meaning it could soon change direction. When a divergence is spotted, there is a significant chance of a price retracement. However, one of the most common problems with divergences is ‘false positives’, which is when the divergence occurs but there is no reversal. A divergence signals that the market is losing momentum but doesn’t necessarily signal a complete trend shift. This makes it important for traders to have a risk management strategy in place to balance the danger of incorrect signals.

There are three types of divergence:

1. Bullish
2. Bearish
3. Hidden

What is a bullish divergences?

A bullish divergence is the pattern that occurs when the price falls to lower lows, while the technical indicator reaches higher lows. This would be seen as a sign that market momentum is strengthening, and that the price could soon start to move upward to catch up with the indicator. After a bullish divergence pattern, it is common to see a rapid price increase.

What is a bearish divergence?

A bearish divergence is the pattern that occurs when the price reaches higher highs, while the technical indicator makes lower highs. Although there is a bullish attitude on the market, the discrepancy means that the momentum is slowing. Therefore it is likely that there will be a rapid decline in price.

What is a hidden divergence?

A hidden divergence occurs when an indicator makes a higher high or a lower low while the price action does not. This often indicates that there is still strength in the prevailing trend, and that the trend will continue. A hidden divergence is used in a similar way to a confirmation pattern.

How can traders use divergences?

Traders can use divergences as a leading indicator, as it precedes the price action. A divergence comes about because a technical indicator does not agree with the current market price, which means that a change in direction is likely. So, traders can potentially use the divergence pattern to enter and exit trades.

However, it is important to note that the technique does not give a set price point at which to open or close a trade, just an indication of the strength or weakness of the underlying market sentiment.

How to identify a divergence

To start looking for a divergence, you should first see whether the price action has reached a higher high or a lower low. It is helpful to draw lines on your price chart in order to see whether this has happened. For example, in the below price chart, we can see that the price has reached a lower low.

Once you have connected the two bottoms with a line, you can use your preferred indicator to see whether the price action differs from your technical analysis tool. The only part of your technical indicator that you really need to focus on here is the tops and bottoms, much the same as your price chart – so it is helpful to draw trend lines on your indicator too.

From the above chart, we can see that the techncial indicator – in this case the stochastic oscillator – has not reached a lower low. This means that there is a bullish divergence, as the downward momentum is weakening and could soon reverse upward.

It is important to note that if you end up missing the divergence, and the price has already changed direction, you shouldn’t rush into a position. In fact, it can be great to look at a longer timeframe and gather data on how a market behaves after a divergence before you enter a position.

You can practise identifying bullish and bearish divergences in a risk-free enviornment by using an IG demo account. This simulated market enviornment gives you the full functionality of our platform, including all of our technical indicators, but you won’t have to put any real capital at risk or be obliged to fund a live account.

Divergence trading indicators

You’ll need to use a technical indicator in order to confirm if a divergence has occurred. There are a few technical indicators that have become popular among traders for identifying market momentum, including:

The MACD

The moving average convergence divergence, more commonly known as MACD, is a moving average-based tool. It looks at the momentum of an asset in order to identify whether a trend will move up, down or continue.

The indicator is made up of three parts; two exponential moving averages (EMA) and a histogram. The two moving averages move around a central zero line. The faster EMA is called the signal line, while the slower line is called the MACD line. If the MACD line is above zero, it is seen as confirming an uptrend, while if it is below zero it is believed to show a downtrend.

When the MACD line and the price of an asset are moving in opposite directions, this is seen as a divergence, which might signal an impending change in the trend’s direction.

However, it is important to note that the MACD is not a perfect indicator, and it can produce unreliable trading signals. The MACD is considered a lagging indicator, because moving averages are based off of historical data. This is why you should always use multiple technical indicators to confirm price action before entering a trade, and have a suitable risk management strategy in place in case of misleading signals.

The stochastic oscillator

The stochastic oscillator compares the most recent closing price to previous closing prices in a given period. This is to show a trader the speed and momentum of a market.

The stochastic is formed of an indicator line and signal line, which are bound on a scale from zero to 100. The scale represents the asset’s trading range over 14 days, and the percentages tell a trader where the most recent closing price sits in relation to the historical prices.

If there is a reading over 80, the market would be considered overbought, and if the stochastic oscillator is below 20, it would be considered oversold. If there is a discrepancy between what is shown on the oscillator, and what is shown on the price chart, this is a divergence.

However, overbought and oversold readings are not completely accurate indications of a reversal. The stochastic oscillator might show that the market is overbought, but the asset could remain in a strong uptrend if there is sustained buying pressure. For example, during speculative bubbles.

Relative strength index (RSI)

The relative strength index (RSI) is an oscillator that is used to assess the direction of market momentum – meaning it can identify divergences and hidden divergences.

Like the stochastic oscillator, the RSI is represented as a percentage on a scale of zero to 100. An overbought signal is given when the RSI crosses the 70 line from above, while an oversold signal is when the RSI crosses the 30 line from below.

For a positive divergence, traders would look at the lows on the indicator and price action. If the price is making higher lows but the RSI shows lower lows, this is considered a bullish signal. And if the price is making higher highs, while the RSI makes lower highs, this is a negative or bearish signal.

Technical traders will often regard an overbought or oversold signal as stronger if it is accompanied by a divergence. Although, as with the other indicators, it is important to note that the RSI signals are not 100% reliable, so it should be used as just one part of a technical strategy.

Bullish and bearish divergences summed up

• A divergence is what happens when the price of an asset is moving in the opposite direction than a momentum indicator or oscillator
• A divergence is often seen as a sign that the current market action is losing its momentum and weakening, meaning it could soon change direction
• Divergences don’t necessarily signal a complete trend shift, which means there might only be a retracement rather than a complete reversal
• A bullish divergence is the pattern that occurs when the price falls to lower lows, while the technical indicator reaches higher lows – it signals a potential upward move
• A bearish divergence is the pattern that occurs when the price reaches higher highs, while the technical indicator makes lower highs – it signals a potential downward move
• A hidden divergence occurs when the indicators makes a higher high or a lower low while the price action does not – it is a continuation signal
• It is helpful to draw lines directly onto your price chart in order to see divergences, connecting tops and bottoms on both the market price and your chosen indicator
• There are multiple momentum indicators and oscillators that can be used to find divergences, including the MACD, stochastic oscillator and RSI