Divergence and Hidden Divergence
Regular and Hidden Divergence on the RSI
Although divergence is not an indicator in that it is not mathematical construct based on past price data, it is often described as a leading indicator and is often a reliable indicator of future price direction, hence its inclusion in this section.
What is Divergence?
Divergence is a phenomena that occurs when there is a difference in the movement of the price action of the underlying financial instrument and the movement of a range-bound, oscillating indicator, such as MACD, CCI, RSI, or Stochastics, etc. This difference is encountered when the price action makes a higher high or a lower low that is not confirmed by the often lagging oscillating indicator. The phenomenon of the indicator not confirming the price action is called non-confirmation.
Divergence can be used in trending markets where it can either confirm the trend or warn of weakness in the trend. For this reason, chart technicians talk of two types of divergence: Regular Divergence and Hidden Divergence.
What is Regular Divergence?
Regular Divergence is the classic sense of divergence that occurs when the price action makes higher highs during an uptrend or lower lows during a downtrend which the oscillating indicator fails to match as it makes lower highs, higher lows, or moves sideways. This non-confirmation by the oscillating indicator indicates a real weakness in the price action and serves as an early warning that the trend is losing momentum and could be coming to an end. In other words, Regular Divergence indicates that there is a good probability of trend reversal occurring.
Regular Divergence is quite reliable though it does not indicate the exact moment when the price reversal will occur. For this reason, traders often rely on other forms of technical analysis, such as trendlines, chart patterns and candlestick patterns, to better time their entry into a trade.
Regular Divergence can be either bullish when it occurs in a downtrend, or bearish when it occurs in an uptrend.
- Bullish Regular Divergence occurs in a downtrend when the price action prints lower lows that are not confirmed by the oscillating indicator. This non-confirmation of the indicator indicates a weakness in the downtrend as selling is less urgent or buyers are re-emerging. When the oscillator fails to confirm the lower lows on the price action, it can either makes higher lows, which is more significant, or it can make double or triple bottoms. The latter occurs more often on oscillators, such as the RSI and the Stochastics Oscillator that are range bound and less often on oscillators such as MACD and CCI that are not range bound.
- Bearish Regular Divergence occurs in an uptrend when the price action makes higher highs that are not confirmed by the oscillating indicator. This indicates a weakness in the uptrend as buying has diminished and selling or profit taking is increasing. As with Bullish Regular Divergence, the oscillator can fail to confirm the higher highs on the price action by either making lower highs, which is more significant, or by making double or triple tops. As with positive divergence, double and triple tops are more prevalent on range bound oscillators.
What is Hidden Divergence?
Hidden Divergence occurs when the price action makes a higher low during an uptrend or a lower high during a downtrend while the oscillator fails to confirm the price action. This often tends to occur during consolidation or corrections within an existing trend and usually indicates that there is still strength in the prevailing trend and that the trend will resume. In other words, hidden divergence is akin to a continuation pattern. As with regular divergence, hidden divergence can be bullish or bearish.
- Bullish Hidden Divergence occurs during a correction in an uptrend when the price action makes a higher low while the oscillator does not. This indicates that there is still strength in the uptrend and that the correction is merely profit taking rather than the emergence of strong selling and is thus unlikely to last. Thus, the uptrend can be expected to resume sooner rather than later.
- Bearish Hidden Divergence occurs during a reaction in a down trend when the price action makes a lower high while the oscillator does not. This indicates that the selling has not waned and the down trend is still strong. The reaction is merely profit taking rather than the emergence of strong buyers and is thus likely to be short lived. As a result, the down trend is more likely to resume in due time.
How to Trade Divergence
Because Regular and Hidden Divergence leads price action, neither gives clear entry signals. Instead, they give an indication of the weakness or strength, respectively, of the underlying trend. As a result, Divergence provides the probable direction of subsequent price action but does not provide the entry level. Therefore, Divergence can be used more effectively in conjunction with other trading techniques, such as trendline analysis, candlestick patterns, and moving average crossovers as a confirmation of the signals provided by those techniques, or vice versa. They can also be used with chart overlays and bands, such as trading envelopes or Bollinger Bands.
Bearish Regular Divergence is quite significant when it occurs near or at an upper resistance trendline, or when a bearish reversal pattern occurs in an uptrend. Bullish Regular Divergence, on the other hand, becomes quite significant when it occurs near or at a lower support trendline, or when a bullish reversal pattern occurs in a downtrend.
- Bullish Regular Divergence occurs during a downtrend when price makes a lower low but indicates a weakness in a downtrend. This implies a reversal of the downtrend to an uptrend. Traders should be looking to go long when the price breaks a resistance line or a bullish reversal candlestick pattern appears.
- Bearish Regular Divergence occurs during an uptrend when price makes a higher high but indicates a weakness in the uptrend. This implies a reversal of the uptrend to a downtrend. Traders should be looking to go short when the price breaks a support line or a bearish reversal candlestick pattern appears.
- Bullish Hidden Divergence occurs during an uptrend when price makes a higher low but indicates strength in the trend. This implies a continuation of the uptrend. Traders could be looking to add to long positions when the price fails to break a support line or a bullish continuation candlestick pattern appears.
- Bearish Hidden Divergence occurs during a downtrend when price makes a lower high but indicates strength in the downtrend. This implies a continuation of the downtrend. Traders could be looking to add to their short positions when the price fails to break a resistance line or a bearish continuation candlestick pattern appears.
Hidden Divergence is the more reliable pattern than Regular Divergence as Hidden Divergence is a trend continuation pattern while Regular Divergence is a trend reversal pattern.
Regular and Hidden Divergence is also more reliable on higher time frames.