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Divergence in Trading: Types, Indicators, Strategies, and a Step-by-Step Guide

There must be price swings of sufficient strength to make momentum analysis valid. Momentum is therefore useful in active trends but it isn’t useful in range conditions in which price swings are limited and variable as swissquote broker review shown here in Figure 4. Price swings aren’t always easy to evaluate with the naked eye because the price can be choppy. Momentum indicators are commonly used to smooth out the price action and give a clearer picture.

  1. Another way to use divergence in trading is to anticipate a potential price reversal and close your existing position.
  2. Technical traders generally use divergence when the price moves in the opposite direction of a technical indicator.
  3. Use trendlines, support/resistance levels, or candlestick patterns in the direction of the prevailing trend to confirm the hidden divergence.
  4. So you’ve connected either two tops or two bottoms with a trend line.
  5. All you can do now is wait for another swing high/low to form and start your divergence search over.

The implication is that the price is losing momentum and is likely to reverse soon. To avoid trade entries that don’t go anywhere, I highly suggest you add other criteria and confirmation tools to your arsenal. A divergence alone is not something that strong enough and many traders experience bad results when trading only with divergences.

This indicator has two lines that fluctuate in different areas on a chart that ranges from 0 to 100. These areas include the oversold zone below the 20 line, overbought zone above the 80 line, and a neutral zone between the oversold and overbought zones. A sell signal occurs when the two lines rise above the 80 line, while a buy signal is shown when the lines dip below the 20 line. Well, it can be caused by various factors, such as changes in market sentiment or shifts in supply and demand.

This can provide valuable information to traders about potential market trends. Let’s examine some examples to grasp better how divergence can be used as a trading strategy. In a bullish divergence scenario, a security’s price is trending downward, but the RSI indicator is moving upward. This signifies that the trend may be on the verge of reversing, and a bullish trade could be made.

Divergence Trading: Everything You Need to Know

Here are some cheat sheets for popular technical indicators and how to use them effectively. In summary, understanding divergence in trading empowers traders with valuable insights into market trends, risk management, and entry/exit timing. It adds a layer of confirmation and versatility to trading strategies, ultimately contributing to more informed and successful trading decisions. Bear in mind that divergence only indicates a loss of momentum, but it doesn’t necessarily signal a trend shift.

Back to Basics: Day Trading Vs Swing Trading

Trendlines, as well as support and resistance levels, should be used in tandem with divergence to guide you in making the most profitable trading decisions. In short, regular divergence exhibits momentum leaving the trend, which could be an early sign of a reversal. Hidden divergence, on the other hand, depicts momentum coming into the current trend, making a continuation more likely. In the stock from Figure 5, Chesapeake Energy (CHK), shares are pulled back to the support.

The Hottest Trading Ideas

Instead, it is vital to complement divergence with other technical analysis methods to confirm trading signals. To summarize, divergence alerts traders of weakening price trends, helping them assess the likelihood of the price changing direction to find better and more reliable trade entries. As well as reversals, divergences can also indicate the continuation of a trend.

A positive divergence is an indication that the price of an asset may move up, while a negative divergence signals that the price is likely to fall. However, it’s important to note that divergence shouldn’t be relied on solely when executing a trade because it may not provide timely trade signals. It can go on for a long time without the occurrence of a price reversal. Backtesting is very important when using divergence cheat sheets because it helps traders determine the effectiveness of their trading strategies in different market conditions. No, traders should not rely solely on divergence cheat sheets for trading.

As previously mentioned, these indicators unveil instances of divergence, enabling traders to base their decisions on the analysis provided by these tools. Consequently, when an indicator reveals a divergence, it serves as a potential warning sign for a price reversal in the actual market. Divergence and convergence in trading are concepts related to the relationship between a financial asset’s price and a technical indicator. Divergence occurs when the price and indicator move in opposite directions, indicating a potential trend reversal. Convergence, on the other hand, happens when the price and indicator move in the same direction, confirming the current trend’s strength. Divergences that indicate a reverse can be either negative or positive.

Divergence signals that the current price trend is weakening and that a reversal may ensue. A negative divergence occurs when an asset’s price is in an uptrend while the indicator is moving lower. Conversely, positive divergence happens when the price is in a downtrend, but the oscillator is moving higher. One of the primary disadvantages of relying solely on divergence cheat sheets is the risk of false signals. False signals can occur when a temporary blip in the price or technical indicator does not represent a significant trend change. Relying solely on divergence cheat sheets can also lead to missed opportunities, as traders may overlook other important technical analysis signals.

Technical traders generally use divergence signals to enter a position when the price swing does not correspond with the oscillator momentum. The key factor to spotting a divergence is to identify when the price is making a new swing high or low and check whether the indicator is making a corresponding swing. Class C bearish divergences occur when prices rise to a new high, but an oscillator stops at the same level it reached during the previous rally.

The three most popular indicators for trading divergence are RSI, MACD, and the stochastic oscillator. Firstly, as technical indicators are not perfect predictors of future price movements, confirmation is crucial for validating the credibility of trading decisions. Secondly, it is used to establish whether the price movement will continue. Class A bearish divergences occur when prices climb to a new high, but the oscillator can only invoke a lower high than displayed in a previous rally.


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