Divergence in trading is one of the clearest early warning signs a trend is losing steam and could reverse. What happens is price pushes to a new high or low, but the indicator doesn’t follow.
Spotting it early, and knowing which signals confirm it, can be the difference between catching a reversal and getting caught in one.
What is divergence in trading?
Divergence, in the sense this article uses the term, occurs when the direction of a technical indicator, usually some form of oscillator, meaningfully deviates from the direction of the price. In other words, the indicator starts moving in the opposite direction to the market. While one interpretation of this would be that the indicator is simply “wrong”, there is in fact a lot of useful information to be gleaned.
Divergence occurs in two basic flavours, which were named without straining any creative muscles:
Bullish divergence: when the price is moving lower but the indicator (at bottom) turns and points up.
Bearish divergence = when the market is declining but the indicator has a negative slope
So, “bullish” or “bearish” refers to the technical indicator and what it signals for the future, not the current market trend.
How does divergence trading work?
Such a change in the direction of the indicator is taken by day traders to mean that the price might be about to follow. In other words, the oscillator in this scenario is used as a leading indicator for the price.
The logic behind using divergence to analyse the market price is that the technical indicator can reveal a slowdown in the momentum of the price. This momentum of the price often changes before the price itself. Markets rarely change course instantly or overnight; before this happens, the speed of a trend slows, and the attitudes of buyers and sellers shift. The theory behind divergence trading is that these phenomena can be measured and used to make predictions.
Think of it like throwing a frisbee into a strong wind. At first, the frisbee will go against the wind for a little while, slowing, and finally it will reverse direction and follow the wind. In this analogy, the wind is a technical indicator: invisible yet pervasive.
What are the best indicators for revealing divergence?
If there is a flawless crystal ball in any part of technical analysis, its owner has so far kept its existence to themselves. The same applies to trading divergence. Every technical indicator has its own benefits and pitfalls. We will cover the three most popular indicators: RSI, MACD and Stochastic.
RSI for trading divergence
The RSI indicator is a momentum indicator plotted as an oscillator underneath the candlestick chart on your trading dashboard, known as an underlay indicator. Its value can vary between 0 and 100.
The RSI is calculated automatically and reflects a moving average of price gains and losses over the previous 14 periods. It was created by J. Welles Wilder Jr, who describes it in detail in his book “New Concepts in Technical Trading Systems”.
Visually, the RSI is a smooth line. Normally, it follows price trends. It can also indicate overbought and oversold conditions. This happens fairly rarely, so the RSI provides traders with fewer signals, but these are more reliable when they do occur.
MACD for divergence trading
The MACD is a momentum indicator that is commonly used in trending markets. This indicator plots a signal line as well as a histogram that shows the difference between two moving averages. In terms of trend following, these tend to converge when a trend is developing or continuing; when they start to diverge, a reversal may be on the cards.
The histogram in particular is easy to interpret visually as far as trading divergence is concerned. However, some judgment is required to identify trend reversals. There are no pre-defined areas of overbought and oversold situations in the MACD display, so deciding which divergence signals are reliable enough to trade on is more difficult.
One common approach is to identify previous peaks on the MACD and treat them as support and resistance levels. However, MACD is most reliable during market trends. When these seem likely to stall or reverse, false signals are common.
Stochastic for trading divergence
The stochastic oscillator is a momentum technical indicator that works by comparing the last closing price with a range of previous prices over the last 14 periods.
The stochastic is a highly sensitive indicator, meaning it will offer frequent divergence signals and thus more potential trading opportunities. Unfortunately, it is highly prone to false signals and should be approached with caution.
Does trading divergence work?
The short answer is: “Yes, but not all the time.” The major advantage of using divergence as a trading signal on when a trade should be entered is that this system provides the signal before the price trend itself has changed. This early signal gives the trader a better entry price for their trade.
The disadvantage of using divergence as part of a sustainable trading system is that you can easily be fooled by false signals. As the phrase suggests, this happens when the indicator changes direction but the price trend does not subsequently reverse as the indicator suggested. This is often the case when a technical indicator suggests highly overbought or oversold conditions. The momentum of the trend may weaken when this happens, but its general direction resumes later.
How to get accurate trading signals from divergence
There are some tried-and-tested techniques that allow traders to reduce the incidence of false signals while still taking advantage of profitable trades.
- Only pay attention to divergence signals when they agree with long-term trends. Alternatively, they can also be useful in a rangebound, sideways market. This is good advice for all the indicators mentioned above and applies to both bearish and bullish markets.
- Always wait for the candle that is might confirm the divergence to close. Indicators generally give their signal according to the current state of the last candle. A sudden change in its closing price can cause an ostensible diverging trading signal to disappear into thin air.
- Use other indicators to confirm the signal, such as support and resistance levels, round numbers, pivot points, or a price action trading pattern.
Setting up your trading platform for divergence trading
Online trading platforms do not go out of their way to make their dashboards difficult to configure. If you run into trouble, most also have decent customer support and extensive how-to libraries.
When viewing an asset’s chart, there should be list of available indicators somewhere in a menu. Simply select RSI, MACD or any other technical indicator that lends itself to divergence trading. Then the indicator will appear on the chart below the price graph. Remember, if necessary, to adjust relevant settings, like the number of time periods over which a moving average is calculated.
Conclusion: Should I trade using divergence signals?
Very few investors, in any market, rely entirely on divergence signals for their trading strategy. While oscillators like RSI or MACD can certainly help to highlight overbought and oversold levels, they are sometimes no more reliable than astrology or reading tea leaves. It’s usually best to use these to flag potential opportunities that may warrant further investigation.
If the idea of divergence trading intrigues you, though, you may as well start by reading books such as Wilder’s, then backtest the strategy you develop before risking capital on its effectiveness.
