Technical Analysis - Divergence

Overview
This article will give a brief overview on divergence in technical analysis, what it is, what indicators show us divergence, and where you are likely to see it
outcome

You will learn how to spot a divergence

Reading time
8 minutes
Experience Level
  • expert Expert

Divergence in technical analysis is when we observe the movement of the price in a direction other than a technical indicator, or is moving against what other data is saying.

This gives a warning that the current price direction may be weakening, and might lead to a change in the current trend.

Divergence has two scenarios.

Bearish divergence: A signal of weakening upwards momentum, or a downward correction. This might occur when the price creates a higher high, and at the same time, the indicator would be making a lower high.

Bullish divergence: A signal of exhausted downward momentum, or an upward correction. This might occur when the price creates a lower low, and at the same time, the indicator would be making a higher low.

What is it? 

Oscillators are a trading tool that can be misunderstood. The oscillators that we will concentrate are momentum indicators. Markets move because of supply and demand and fear and greed. Momentum oscillators are a measure of these movement 

When bearish or bullish price moves start to lose their momentum, divergence occurs.

The easiest way to explain this is to look at a Wedge formation:  

Ascending Wedge with Bearish Divergence:  


The chart above highlights an Ascending Wedge formation. We have a trend of higher lows and a trend of higher highs. What makes the wedge is the lower trend support is at an angle of 20 degrees. The upper trend line resistance is at an angle of just 5 degrees. These angles will vary. What is important in an Ascending Bearish Wedge is that the upper trend line resistance is a lower angle than the lower trend line support.  

What else can we note? The distance of the first impulse rally is 8.71% or 876 pips. The second impulse rally is 5.68% or 574 pips. This highlights that bulls are starting to loss strong upside momentum with shorter rallies. The wedge is like a coiled spring, with rallies getting smaller and smaller, and the wedge getting tighter a tighter, ready for an impulse breakout to the downside.  

As we can see, the chart is making a higher high, while the oscillator is making a lower high, indicating a bearish divergence.

Bearish Divergence can be seen. The chart makes a higher high, while the oscillator makes a lower high.   

What indicators should I use

This can be your own preference. We would suggest any of the following: 

  • RSI (Relative Strength Index)
  • Momentum
  • RoC – Rate of Change 
  • Stochastics  

Where am I likely to see Divergence 

Chart formations that are likely to highlight divergence are:  

Double or Treble Bottom or Top.

Wedges

The 5th wave in Elliott Wave.

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