In general, divergence means that something from a common center extends in a different direction. In layman’s terms, something is different from the standard course.
But what is divergence in trading?
Let us say that the price of an asset is expected to move in a certain direction according to a technical indicator, but it moves the other way around; we call this divergence. It is a technical analysis concept.
If we cite an example, the asset price says higher highs, but the indicator displays the opposite, which is lower lows. However, it does not always suggest that the trend will reverse. It only means or indicates that something might be changing. It suggests that a trader should consider other strategy options like holding, covered call sale, stop tightening, or taking a part of the profits. If we think about it, it is more of an ego question than the idea of profits. To be profitable, one must know the perfect strategy for the price status and not the following price actions.
Why do traders use divergence?
A trader may decide to use divergence to know if the market is starting to weaken. When there is a weak market, there is a possibility of two things: trend reversal or a consolidation period.
A trend reversal is more self-explanatory. It is an occurrence when an upward trend becomes lower and vice versa. On the other hand, in a consolidation period, activity is bound to a range after a long-term price move. During this time, the trading range does not see any trend since the price consolidated it. We can usually see this occurs after a downtrend or uptrend, and it is a stretch of indecision. Consolidation tends to happen as soon as price breaks through existing support and resistance lines.
More on divergence
In a sense, the amount of trading can be an indicator that produces divergences. For example, if the trading volume is in a specific direction and a price moves the opposite way, the price creates a divergence. Furthermore, if there is a decreasing volume, but the price is decreasing, there is divergence. If a price declines but the trading volume is high, there is divergence.
Divergence usually works hand in hand with technical indicators such as momentum oscillators, even though they happen between the price and other data. Some examples of these oscillators include Commodity channel index or CCI, Relative strength index or RSI, and Williams %R.
The two types of divergence
Divergences can be classified into two types: regular or hidden. These two may either have a bullish or a bearish bias. Let us explain them more:
- The regular divergence. A regular bullish divergence is when the price makes lower lows while the oscillator is higher highs. On the other hand, a regular bearish divergence is when the price makes higher highs while the oscillator is lower high.
- The hidden divergence. Divergence is a hidden bullish when the price makes a higher low, while the oscillator makes a lower low in an uptrend. Hidden bearish divergence is when a price makes a lower high, but the oscillator makes a higher high in a downtrend.
To summarize A regular divergence may mean that there will be a trend reversal, while a hidden divergence may mean that there will be a trend continuation.