In trading, divergence is an important signal often used by traders to detect potential trend reversals or continuations. Divergence refers to the difference between the direction of price movement and the direction of technical indicators. Typically, divergence is first detected in indicators such as the Stochastic Oscillator, Relative Strength Index (RSI), or MACD.
This article will discuss the meaning of divergence and its types, which you can use as part of your trading strategy.
What is Divergence?
Divergence occurs when the price direction on the chart does not align with the direction of the indicator. When the price moves in one direction, the strength of the trend begins to weaken, signaling a potential trend reversal. Divergence can form in two directions:
- Bullish Divergence: A signal that the market may soon rise.
- Bearish Divergence: A signal that the market may soon fall.
1. Classic Divergence
Classic Divergence is the most common and easiest type of divergence to recognize. It indicates that the market will soon reverse direction. There are two types of Classic Divergence:
- Classic Bearish Divergence: Occurs when the price makes a Higher High (a higher peak than the previous one), but the indicator shows a Lower High. This is a signal that market momentum is weakening, and the price is likely to fall.
- Classic Bullish Divergence: Occurs when the price makes a Lower Low (a lower trough than the previous one), but the indicator shows a Higher Low. This signals a potential upward reversal, where the price is likely to rise.
Classic Divergence generally indicates that the ongoing trend will soon reverse.
2. Hidden Divergence
Hidden Divergence is rarer than Classic Divergence but is important because it often signals trend continuation rather than reversal. Hidden Divergence indicates that the market will continue its current trend.
- Hidden Bearish Divergence: Occurs when the price makes a Higher High, but the indicator shows a Lower High. This indicates that the downtrend will continue, even though the price appears to be temporarily rising.
- Hidden Bullish Divergence: Occurs when the price makes a Lower Low, but the indicator shows a Higher Low. This signals that the uptrend will continue, despite a temporary price drop.
With Hidden Divergence, the signals typically indicate that the market will remain in the same trend.
3. Extended Divergence
Extended Divergence is a variation of Classic Divergence, where the price movement pattern is more closely observed than the indicator level. Extended Divergence indicates that the market may not be ready for consolidation and will continue the current trend.
- Extended Bearish Divergence: Occurs when the price chart shows similar Higher Highs, but the indicator shows a Higher High followed by a Lower High. This suggests that the market will continue to fall.
- Extended Bullish Divergence: Occurs when the price chart shows similar Lower Lows, but the indicator shows a Lower Low followed by a Higher Low. This signals that the market will continue its uptrend.
Extended Divergence often provides strong signals that the market will remain in its current trend, despite small reversals.
Divergence is a highly useful tool in technical analysis, especially for those looking to detect potential trend reversals or continuations. However, it’s important to remember that divergence is not always easy to recognize, especially in dynamic market conditions. To effectively utilize divergence, experience and consistent practice are required.
By mastering the three types of divergence—Classic, Hidden, and Extended—you can become more confident in making trading decisions based on technical analysis. The more you practice and analyze divergence, the easier it will be to detect these patterns on live charts and capitalize on available opportunities.
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