Divergence in technical analysis occurs when the price of an asset and a related technical indicator move in opposite directions. This phenomenon is often considered a warning sign that the current price trend may be weakening, which could eventually result in a price reversal.
Types of Divergence
Regular Divergence
Regular Divergence is typically a predictor of potential trend reversals. It can be classified into two subtypes:
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Bullish Regular Divergence: This occurs when the price makes lower lows, but the technical indicator makes higher lows. It suggests a potential upward reversal in the asset’s price.
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Bearish Regular Divergence: This happens when the price makes higher highs, but the technical indicator makes lower highs, indicating a possible downward reversal.
Hidden Divergence
Hidden Divergence is considered a continuation signal, suggesting that the current trend will continue.
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Bullish Hidden Divergence: Occurs when the price makes higher lows, but the technical indicator shows lower lows.
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Bearish Hidden Divergence: Happens when the price makes lower highs, but the technical indicator makes higher highs.
Special Considerations
It’s important to remember that while divergence can serve as a valuable tool for predicting potential price reversals, it should not be used in isolation. Traders often combine divergence with other technical analysis tools to confirm signals and improve accuracy.
Examples of Divergence
Let’s consider a chart of a stock where the Relative Strength Index (RSI) is used as the technical indicator:
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Bullish Regular Divergence Example: The stock price makes a series of lower lows, but the RSI forms higher lows. This divergence can hint at a weakening bearish trend and signal a potential upward price movement.
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Bearish Regular Divergence Example: The stock price reaches higher highs, but the RSI prints lower highs. This suggests that the bullish momentum is fading and a downward reversal might occur.
Historical Context
The concept of divergence has its roots in the development of technical analysis in the early 20th century. Traders like Charles Dow and later analysts such as John J. Murphy have discussed the importance of divergence in understanding market behavior.
Applicability
Divergence is applicable across various financial markets including stocks, forex, commodities, and cryptocurrencies. Traders use it to fine-tune their entry and exit points, making it a versatile tool in technical analysis.
Comparisons and Related Terms
- Convergence: Opposite of divergence, where price and indicators move in the same direction.
- Overbought/Oversold Levels: Often used in conjunction with divergence to identify potential reversal zones.
FAQs
What is the primary use of divergence in trading?
The primary use of divergence in trading is to identify potential weakening trends that may lead to price reversals.
Can divergence be used for all assets?
Yes, divergence can be applied to various assets including stocks, forex, commodities, and cryptocurrencies.
Should divergence be used alone for trading decisions?
No, divergence should not be used in isolation. It is best used in combination with other technical analysis tools to confirm trading signals.
References
- Murphy, John J. “Technical Analysis of the Financial Markets.”
- Wilder, J. Welles. “New Concepts in Technical Trading Systems.”
Summary
Divergence in technical analysis is a crucial concept where the price of an asset and a technical indicator move in opposite directions. It serves as a warning sign of potential trend weakening and possible price reversals. Understanding the types, historical context, and practical applications of divergence can significantly enhance a trader’s strategy, making it a vital tool in the technical analysis toolkit.
