Divergence is the direction of the price, which is observed when it is moving in the opposite direction of a technical indicator. 

When a stock diverges from its path, it is said to go through a trend reversal in the stock market. So, for example, if the security is in a bullish movement, the direction change to a downward movement will be denoted as a trend reversal with the downtrend. 

Certain kinds of divergence, positive, negative, bullish, and bearish, should be known to traders to grasp the trend reversal moments. Moreover, in this blog you will learn about the rules for using divergence in stock market trading and more as follows:

1. What is Divergence? 

Divergence occurs in the stock market when an asset’s price moves away from each other to move on another side. Technical trades use divergence indicators to protect their ongoing profit and to square off immediately during the divergence. 

When the stock price hits higher highs, although the indicator does not, divergence forms in the situation as it makes lower lows, and the indicator does not. 

The above figure shows that divergence occurs when there is a high probability of price retracement. It shows no possible reversal, although the trend has changed differently. 

2. How to trade divergence

Divergence Trading is critical as it is not profitable all the time. Therefore, a trader should keep the knowledge through rigorous practice and consistency in trading. 

However, if you are using indicators like MACD and RSI, the divergence can be effective in your trading strategy. 

We have prepared 7 rules for trading divergences that can help you focus on your trade:

 

2.1 Make sure that the price is either formed in one of the following ways

•  Double Top

•  Double Bottom 

•  Higher High 

•  Lower Low

 

2.2 Draw lines from the tops and bottoms 

Next, draw the line in the chart from the high to the previous high or from the low to the previous low. 

2.3 Connect the tops and bottoms 

Make sure to connect the two highs on the tops, which have been established through the security price by drawing a trend line. Further, if there are two lows formed, you connect the bottoms.

2.4 Watch the Price Movement 

Don’t forget to keep watching the price movement as you draw the tops and bottoms for analyzing trading divergence. 

 As you connect two bottoms and two tops with a trendline, the price action should be judged with a prominent technical indicator. 

Some indicators, like Stochastic, consist of several lines, so you use that to compare with the tops and bottoms.

2.5  Swing Highs and Lows

When you draw lines for the two highs and two lows in the chart, make sure you also draw the highs and lows in the indicator segment as well. 

The swing highs and lows on the tops and bottoms should match with the indicator to derive the analysis as correct. 

 2.6 Vertical Alignment

 Always, we repeat! ALWAYS maintain vertical alignment with the security price’s highs and lows and the indicator’s swing lows and highs.

In the same manner, when you draw the slopes connecting the indicator’s highs and lows as well as the price highs and lows, they should differ to create divergence. The slope is either ascending, descending or flat.

Now, if you have spotted the divergence but the price is reversing and moving in another direction, you should know that it is a false signal. 

2.7 Positive and Negative divergence 

Traders use divergence to assess the likelihood of a security price reversal. For example, on a price chart, an ideal situation occurs when the stock is making new highs and the RSI is also reaching new highs. In contrast, if the stock is reaching higher highs but the RSI is making lower highs, it signals that the uptrend is coming to an end. This is known as negative divergence. 

In another case, if the stock price is reaching new lows whereas, the RSI is making higher lows, it will be known as positive divergence. Therefore, traders will predict in this scenario that bearish momentum is coming to an end, and a trend reversal might happen soon.

A positive divergence signals that an upward movement is possible, whereas a negative divergence signals that a lower move in security can take place. The figure above explains the situation. 

3. Bullish and Bearish divergence 

Divergence can be bullish and bearish divergence and defines the direction of the stock price. A bullish divergence is formed through lower lows by the price and higher lows by the signal line of the oscillator. 

What is Bullish Divergence? 

The bullish divergence uses a special setup with price and RSI signal, known as a failure swing. The principle of spotting and charting is similar in RSI and MACD signals for divergence.

Therefore, the bullish divergence using both indicators is in the figure below: 

What is Bearish Divergence? 

Bearish divergence, on the other hand, forms higher highs for the security price and lower highs for the signal line of the oscillator.The RSI and MACD signal can form a bearish divergence in this setup. While preparing for MACD bearish divergence, it is essential to identify two lower highs on the MACD indicator line.

For example, the MACD signal with price shows the bearish divergence as follows:

4. Limitations of using divergence

A divergence can help you predict the next movement or trend reversals through several aspects. Still, it has a lot of limitations that you must read before implementing divergence. 

• A divergence indicator is not suggested to use standalone while determining a trend reversal. 

• There is a chance that diverging patterns can occur, although the price might never reverse. So, it Is important to confirm with several indicators as well.

• Using divergence to find entry and exit points can be a risk to the traders when analyzing it without support from oscillators. 

• While forming the setup for divergence, it is important to have other indicators complement the analysis, such as RSI, MACD, and Stochastics, to reaffirm the patterns formed in the analysis.  

Conclusion

The divergence tells the traders that when the stock price is providing a direction to opposite signals of the price. Therefore, it is essential to have confirmation with several kinds of other indicators to develop an accurate analysis. 

It is important to watch the price movement to find the divergence signals in the stock price. Although divergence has many limitations, it can be overcome when used with the right steps and the correct combination of indicators. 

 Key Takeaways

• Divergence moves in the opposite direction of the technical indicator.

• Divergence occurs when there is a high probability of price retracement. 

• Divergence analysis is recommended only if you observe double top, double bottom, higher high, and lower low formation. 

• Maintain vertical alignment in oscillators with security’s price

• If the price is reaching higher highs and RSI is in lower highs, the uptrend is coming to an end – negative divergence.

• If the price reaches new lows and RSI is in higher lows, the downtrend is ending – positive divergence.

• Bearish divergence, on the other hand, forms higher highs for the security price and lower highs for the signal line of the oscillator.

• Bullish divergence is formed through lower lows by the price and higher lows by the signal line of the oscillator.