Divergence in financial markets
Divergence in trading financial instruments (currency, commodity, equity markets) is the opposite directional movement of the price on the chart and the indicator (most often the oscillator).
Such signals are encountered quite often on different timeframes, and can warn us of an imminent reversal or continuation of the current trend. Therefore, divergence signals should always be a reliable and working tool for traders.
Divergence of reversal
Type 1
The first type of divergence is the strongest. Often, a divergence between a price and an indicator of this type is a signal of an imminent and rapid reversal.
A sell signal appears when the price reaches a new high and the indicator shows a decrease in comparison with the previous high.
If a new minimum is formed on the price chart, and the new extreme of the oscillator is higher than the previous one, then a buy signal is being generated.
Type 2
Divergence of the second type is a signal of medium strength. It also indicates a weakening of the current trend and an upcoming reversal or correction. Divergence of the second type should most often be confirmed by other signals.
Bearish divergence of the second type occurs when the price forms a double top, and the new extreme of the indicator is below the previous one.
In the case of a bullish divergence of the second type, a double bottom forms on the price chart, and the oscillator's extremes rise.
Divergence signals of the second type are less reliable, the price may have a reserve of price momentum, and it cannot be ruled out that it stopped just for the sake of rest and will soon resume its movement.
Type 3
Divergence of the third type usually forms in high volatility markets and many authors recommend ignoring it.
In this case, a double top / bottom appears already on the indicator, while the price is updating the extreme. This may indicate that the current momentum retains the momentum.
From trading experience, we can also say that the most reliable divergence signals occur when the price reaches significant resistance / support levels, as well as when trading fifth waves and reliable patterns appear on the chart.
Double divergence
To identify a classic divergence, it is often enough to find a divergence at two extremes. However, there are times when the price continues its trend and the indicator continues to indicate a divergence. In this case, a double divergence is formed.
Such a signal is considered more powerful and reliable in comparison with the divergence at two extremes. Double divergence often occurs during important news or at the end of powerful trending moves.
Hidden divergence
Along with the classic divergence, there is also a hidden divergence. Many traders often forget about it, while hidden divergence is a very strong signal for the continuation of the current price movement.
When in an uptrend, price lows rise and indicator troughs form new lows, then a hidden divergence occurs and the upward price movement will continue.
When in a downtrend price highs are declining, but at the same time as the oscillator extremes rise, we can talk about hidden bearish divergence, indicating a stable downtrend.
Oscillators that can be used to determine divergence: Stochastic, RSI, MACD, CCI, Bill Williams indicators (AO, AC), momentum and other indicators.