Divergence Trading Explained

Don’t you ever feel like going rogue? 🥷

It’s not like we all have to go full Breaking Bad and start cooking you-know-what and getting into other murderous shenanigans. It might be as simple as stealing a pencil from your office job (scandalous!), or having that extra bowl of ice cream after a good workout (delicious!). No matter how big and small, most of us need a break from routine at least some of the time.

As much as we like to predict what forex and stock prices are going to do, those little squiggly lines can go rogue some of the time, too. We have all our technical indicators trying to see what security is going to do next – and sometimes, it starts to move right in the opposite direction of what the indicator says it’s supposed to be doing. 

In stocks and forex, that’s not called going rogue – it’s called divergence. But it’s basically the same concept as Walter White screaming at his boss about his eyebrows – or at least, we’re going to pretend it is. Divergence can often mean a price is about to change direction, and if you can predict that, you stand to make a pretty penny.

The market has been a tricky thing recently, with Moderna stocks seeing a 15% crash in August and the market still reeling from GameStop. Divergence trading is another tool that can help you make better predictions, and thus better trades. This guide will help you understand what divergence is, what it means, and how to interpret and trade different types.

So let’s go rogue!

What you’ll learn

• What is Divergence Trading?
• What Does Divergence Tell Us?
• Types of Divergences
• How to Trade Divergence
• Divergence Trading Rules
• Get Started with a Stock Broker

What is Divergence Trading? 💭

Learning technical analysis is an important part of trading stocks and forex. There are plenty of indicators in forex that can help you determine when to buy, whether to go short or long, and what the momentum of a current trend looks like.

Divergence is when an asset’s price moves in the opposite direction that an indicator says it should. For example, in the below chart, we see that the high price of the security is moving upward, while the oscillator shows that the high prices should be moving downward. 

Divergence traders will keep an eye out for these moments of divergence, as they may signal a price change. As always, divergence should be combined with other indicators, as well as world news, such as predictions that the stock market is rolling over amid new highs.

What Does Divergence Tell Us? 🤔

What does Divergence actually mean? Well, divergence can be a sign that the security is about to see a significant price move in either direction. Make sure you are comfortable reading forex charts so you know how to spot a difference between the chart and the indicator. 

Divergence can help traders identify the momentum an asset’s price has, and determine whether a price reversal might be likely. It’s helpful to compare the price chart with oscillators such as the Relative Strength Index (RSI). If the security is reaching new highs but the RSI is making lower highs, that means momentum on an uptrend is slowing – which might be a good time to exit the position, or at least set a stop loss. 

Divergence can also mean that a price reversal is imminent, but it does not predict all price reversals, and traders might wait a long time before the reversal happens. It’s always a good idea to compare findings from divergence with other indicators, as well as world news.

Even if you’re day trading, context is important: your divergence discovery might mean something different with the knowledge that South Korean markets are sliding downward, or that the dollar is reaching 4-month highs.

Types of Divergences 💡

Not all divergences mean the same thing. It’s important to know whether a security is shifting because it’s overbought or oversold, or because major economic or political news just broke – or even just the news that Tesla is teasing humanoid AI bots in development. Let’s go through the types of divergence and what to expect from each of them. 

Bullish Divergence 🐂

A bullish (or positive) divergence occurs when a security’s price falls, but the indicator starts to rise. This signals that even though the price is going down, its downward momentum is slowing, and it may start to move upward very soon. After confirming with other indicators and world events, a trader may decide that bullish divergence means the price will soon be going upward, and it is a good time to enter a trade. 

Bearish Divergence 🐻

A bearish (negative) divergence is essentially the opposite of a bullish divergence – no surprise there! If you see an asset’s price start to rise while the indicator starts to fall, that means that the upward momentum of the price is starting to slow down. 

Bearish divergence could be a sign that you want to exit the trade or set a stop loss in case it goes past a certain point. It could also be a good time to enter a short position – and according to Jim Cramer, short-sellers have been a big part of the market’s COVID rally.

Regular Divergence & Hidden Divergence ⚔️

Regular divergence refers to the positive and negative divergence patterns that we’ve seen above. Regular divergence is a sign that the security’s price is about to reverse because an uptrend or downtrend is weakening, as shown by the technical indicator. 

However, there is another type of divergence that shows that a trend is likely to continue. That’s called hidden divergence, and it helps us feel extra sneaky and smart in our trading process, which we love. We’re basically detectives now. But before you get out your magnifying glass and old-timey Sherlock Holmes hat, let’s make sure we understand the difference between regular and hidden divergence.

In this infographic, the sharp lines at the top (light green) represent price lines, and the squiggly lines below (blue) illustrate the MACD indicator. During a downtrend, we measure regular divergence off the lows of the price and the indicator; during an uptrend, we measure off the highs of both. 

As you can see, hidden divergences are quite different from regular divergences—lower highs followed by an opposite movement on the MCAD indicator are a bearish signal. And, a bullish hidden divergence is the exact opposite.

Hidden divergence can be found in the opposite way of regular divergence. While regular divergence looks at lows during a downtrend and highs during an uptrend, hidden divergence will look at lows of the price and the indicator during an uptrend and the highs of both during a downtrend. This divergence, cleverly named, is completely opposite from the regular one.

First, we can see the higher lows of the price correspond with lower lows in the histogram. Then, we see higher lows in the price just as we see a double bottom in the histogram. Both show bullish hidden divergence indicating that the momentum of the price is going to continue upward. 

How to Trade Divergence 💰

As you may have gathered, divergence can be found with a number of different indicators. Which one you use is ultimately up to you and your comfort level with different types of technical analysis, and what your broker offers (though the top forex brokers will offer all the big ones). There are a few differences in spotting divergence based on which indicator you’re using, so let’s walk through some of the major ones to make sure you’re ready to go.

Using the MACD 💸

The MACD ( Moving Average Convergence and Divergence) is a very popular indicator that essentially “slows down” trend lines so that you can see what a price is doing over longer periods of time. Basically, it compares a moving average taken over a certain shorter time period to a moving average taken over a longer time period. 

In general, the most popular MACD time periods are 26 days and 12 days, plus a signal line that will show you a 9-day moving average. These moving averages turn into an oscillator composed of two lines. When these lines cross each other, they signal that a trend may be reversing soon. 

Using the MACD to spot divergence is relatively straightforward. If the price of a security reaches a new low while the MACD reaches a higher low, that is a bullish divergence. This means that the current trend is losing momentum. 

If the price of a security reaches a new high while the MACD reaches a lower high, that is a bearish divergence. This again signals that the trend is losing momentum. 

Using the RSI 🤑

The RSI (Relative Strength Index) is another popular indicator that is used to identify whether a security is overbought and oversold. It essentially calculates the average gains and losses over a certain period, so that the trader can see whether the current price has gone out of its normal, stable range. 

The RSI is measured on a scale from 0-100. In general, an RSI below 30 is considered a buy signal as the market is oversold; an RSI above 70 is a sell signal when the market is overbought. If you see the RSI rising while the security’s price is falling, that is a divergence.

Using the Stochastic Oscillator 💳

The stochastic oscillator is another indicator to determine whether the market is overbought or oversold. It is composed of two lines and indicates a bullish trend when there is a crossover below the lower line, and the lines continue to rise. A bearish trend can be found when there is a crossover above the higher line, and the lines begin to fall. 

A bullish divergence occurs when the security’s price is dropping but the lines of the oscillator are going up. A bearish divergence is when the oscillator lines are dropping, and the security’s price is rising.

These are just a few popular indicators that can be used to spot divergence. You can also use momentum, relative vigor index, and other indicators that you are comfortable with. It’s always a good idea to employ multiple indicators so that you can confirm your theory. 

Divergence Trading Rules 📜

Now you understand what divergence trading is. But how exactly should you employ it? There aren’t necessarily hard-and-fast rules that can help you make exactly the right trade at exactly the right time – but there are certain guidelines that can help you make better trades.

Double-Check Your Divergences 💵

First, make sure what you’re seeing is actually a divergence. There are key ingredients that a divergence has to have. Make sure your security has formed either:

• ☑️ Higher high 
• ☑️ Lower low 
• ☑️ Double top
• ☑️ Double bottom

If none of these are present in the price, it doesn’t matter what the indicator says – it’s not a divergence. Remember, not all highs are higher highs – we need to see a new breakthrough or extreme to qualify. Make sure that at least one of the ingredients is applicable.

Draw Some Lines 🏦

Now that you’ve identified your major price marker, you’re ready to draw some lines on your chart. Connect your higher high with the previous high – we want to see consecutive major highs or lows, whether that’s creating a diagonal (higher highs / lower lows) or a straight line (double top / double bottom). 

Remember, for a regular divergence, you’re looking at the higher highs for regular bullish divergence, and the lower lows for regular bearish divergence. Swap those if you’re on the lookout for hidden divergence to confirm the momentum of a trend.

Compare Price with the Indicator 💶

Compare your price to what the indicator is doing. No matter what indicator you’re using and how many lines you’re seeing, just focus on the tops and bottoms formed by the indicator. 

Remember, if you’re looking at highs on the price, you have to look at highs on the indicator as well. Don’t compare highs on the price with lows on the indicator! 

These highs and lows need to line up vertically – so the points need to come at the same moment in time. Otherwise, they are meaningless. 

Pick Your Trades 💶

If you’ve spotted a divergence but the price has already started to reverse, it may be too late to enter the trade. Don’t worry – you can still pat yourself on the back for finding one! But look out for the next one before you spend your hard-earned cash. 

Divergence also tends to be more reliable on longer time frames rather than shorter time frames. Divergences on charts less than one hour may occur more often, but they less reliably signal a change in price direction. 

Conclusion 🏁

Now you have a new tool in your toolbox to figure out when a price is going to change direction. If you’ve been watching the news of the 50 richest people in Singapore increasing their wealthy by 25% and wishing you could turn your money into more money, divergence trading could be a way to start doing that. 

But remember, like all technical indicators, divergence isn’t a crystal ball. Compare your findings with news sources, and review a few other indicators to see whether they’re telling you the same thing. Keep track of how often your divergence trades are panning out, and how often you’re stuck waiting on a price reversal that never happens – that might indicate whether you need to adjust your strategy. 

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DIY stock trading

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8.0/10 Visit Robinhood on Robinhood's website

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Fees

Account minimum

$5 required to start investing

$0

$0

Minimum initial deposit

$0 to open account

$0

$200

Commissions

$3 or $5/month

$0

Vary

General

Promotion

Free stock

Best for

People who struggle to save

DIY stock trading

Large investment selection

Highlight

“Invest spare change” feature

Pioneer of commission-free stock trading

Low fees

Rating

7.0/10 Visit Acorns on Acorns' website

8.0/10 Visit Robinhood on Robinhood's website

9.0/10 Visit Pepperstone on Pepperstone's website

About the author

Tim Fries

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Tim Fries is the cofounder of The Tokenist. He has a B. Sc. in Mechanical Engineering from the University of Michigan, and an MBA from the University of Chicago Booth School of Business. Tim served as a Senior Associate on the investment team at RW Baird's US Private Equity division, and is also the co-founder of Protective Technologies Capital, an investment firm specializing in sensing, protection and control solutions.