Classification of Divergence
Divergences precede the price action. It results from a strong disagreement between the price action and the technical indicator that the trader is using. As the opposite of the bearish divergence, a bullish divergence occurs when the prices reach the lower lows, but the indicator shows a higher low. This indicates that an upward trend is likely.
To understand the investor’s approach to the market, indicators are the most accurate representation. They help in analyzing if the market is “oversold” or overextended to the downside.
As discussed before, a bearish divergence occurs when the price reaches a higher high, but the indicators show a lower high. This means that a downward trend is likely. This situation indicates the market is coming out of the bullish divergence (upward trend), and it is overextending or “overbuying” to the upside.
Divergences are of different strengths. Whether bearish or bullish, their strength foretells the traders about the possible market situation. Class A divergence, being the strongest, indicates the best time to trade. On the other hand, Class B (of lesser strength) and Class C (the weakest) divergences are not favorable. Traders avoid them as they are full of uncertainties.
Class A bearish divergence is when prices touch a new high while the oscillator fails to keep up. It can only reach the price that is lower than the price in the previous rally. It also signifies a sudden return towards a downtrend. When the prices decline to a new low, and the oscillator fails to reach the low point shown in the previous decline, it is Class A bullish divergence. It is the best indicator that a sharp rally is approaching.
When the prices make a double top while the oscillator traces a lower second top, Class B bearish divergence occurs. Thus, it can be said that the prices trace a double bottom, and the oscillator traces a higher second-bottom when there is a Class B bullish divergence.
Class C bearish divergence is when prices move upwards and create a new high, and the indicator doesn’t follow that lead. It remains at the same level as the last rally. Class C bullish divergence is when prices drop to a new low, and the indicator shows the price at the double bottom. Class C divergences indicate stagnation in the market. This means that the bulls and bears are neither becoming stronger or weaker.
Divergence oscillators are indicators that the current price trend may be changing. They mark the high and the low bands between two extreme values in the market, and then the trend indicators fluctuate between these bands. If the oscillator falls short of reaching the new low, created by the fall of the prices, the bullish divergence occurs. When the bulls rule, the end of the downtrend begins. During bullish divergence, the bull gains control of the market again while the bear loses power.
Bearish divergence hints towards a potential downtrend as the prices reach a new high. It stands in contrast to the bullish market. Here, the oscillator fails to touch the new high. As the prices rise due to inertia, the bear prepares to take charge.
How Rate of Change and Momentum Effect the Market
Divergences help the traders to identify the accurate point when the market’s momentum may change. Along with aiding in identifying an upcoming change, the traders can also discover the speed and the direction of the approaching momentum. These changes can be high speed, low speed, or may remain stagnant in progress. To find out this speed, the best tool is Rate of Change. The trader can compare the present-day closing price to the closing price Y days ago using Rate of Change.
RoC= Today’s closing price / Closing price days ago
The RoC was the ratio of today’s closing price to the closing price Y days ago. If today’s price is greater than the previous price, RoC is greater than 1. If today’s price is smaller than the previous closing price, the RoC is smaller than 1. RoC is 1 if both the prices are equal. When these RoC values are plotted as a linear diagram, they demonstrate whether the RoC is rising or falling.
Another way to discover the speed of the market’s change is to calculate its momentum. It is similar to the Rate Of change, but instead of giving a ratio, it gives you a number. A trader will subtract the previous day’s closing price from the current closing price to calculate the exact momentum.
Momentum (M)= Today’s closing price – Closing price Y days ago
These momentum prices are calculated every day. They give the traders points to create a linear presentation. This linear presentation helps to understand the trend of the momentum, whether it’s rising or falling. Momentum can be positive or negative, depending upon which price is higher. If the previous price is higher, it is negative, and if today’s price is higher, it is positive. It can be zero if both the prices are the same.
Use of Momentum for the Traders
The first step for the trader is to select a time window while calculating the RoC or the momentum. This time window is generally advised to be kept narrow in case of the oscillators. While trend-following indicators work best for the long-term trend, oscillators are best for detecting short-term changes in the market, like assessing the momentum of a week.
When the RoC or the momentum reaches a new high, the market becomes positive, and the prices probably go higher. When this two fall to a new low, the situation indicates that there might be a decline in the market, and the prices may also fall.
When the RoC or the momentum fall but the prices rise, traders may expect a top approach. This indicates a good time for those in a long position and wants to lock in their profits or tighten their protective stops. A bearish divergence occurs when prices reach a new high with Roc or momentum reaching a lower top. This indicates that the time is good to sell. At the same time, the bullish divergence indicates that the time is good to start buying.
A market is a very uncertain place where the traders’ expectations can be challenged at every step by strong indicators. But, these differences between the expectations and the reality make a trader strong with his trading skills.
Part One: Trading Divergence
As the name suggests, a divergence is when the price and the technical indicator (such as an oscillator) move in opposite directions. Divergence indicates what a trader can expect in the future about the movement of the prices. They could indicate both a positive and negative movement of the price.
The situation above is that of a bearish signal; that is, the prices show higher highs, but the indicators show lower highs. But unlike the bearish signals, there is an indication that the trends are improving as the RSI (a technical indicator) shows higher lows.
This is a warning for the QQQQ shorts as it indicates that it would be imperative to do risk control as the possibility that the trends will get unstable in the short-run is on the higher side.
Oscillators are critical technical indicators. They help traders simplify the complexities in the market and ascertain the prices between the extremes and discover if there are any chances of a price reversal situation.
They can understand this by studying the relationship shared by bearish price action and oscillator trends. If there is a disagreement or divergence between the two, where the former shows lower lows while the latter is showing higher lows, it could mean that the investors’ sentiments are overreaching.
Bullish and bearish divergences can take trade in either of the directions.
Bullish divergence signals that the trader can expect a positive trend in the market. Its onset indicates that it is safe to enter the market in a new long position, and its end warns the trader of a likely downward trend. However, a bearish divergence is also important to be considered by long traders. Bearish signals indicate that the momentum is likely to get slow so the trader can determine whether he wants to stay or exit the market.
Let’s look towards a clear divergence analysis to understand how divergences help in regular trading practices and which type of divergence gives more accurate information to ascertain the traders’ next move.
A bearish signal, as discussed before, is the situation when the price reaches higher highs, but the oscillator (here, RSI) is demonstrating a lower high. This indicates that the prices are likely to show a downward trend.
This signal is also considered to be the session of diverging trends between the indicator and prices when the indicators reach peaks in the “overbought” territory.
Sometimes traders use RSI (Relative Strength Index) as an indicator to discover divergences. RSI states that the values of 70 or above indicate that the securities are becoming overbought, and the traders tend to pay more attention to the divergences in this situation. The below chart indicates the same situation and a downtrend of eBay.
When the indicators do not agree with the current price, i.e., when the divergences form and begin to drop, the technical traders have two choices. First, long traders have the opportunity to go safe and be calculative about risk control. They can do so by putting a stop price (tight stop), review the security portfolios, or take protective options.
Additionally, a bearish divergence provides great opportunities for speculative trades for the short market and buy put options. It is up to the trader which course of action they would take. The signal has given them actionable information.
In simple words, the application of divergence to different indicators is fundamental and simple. With just basic knowledge, one can understand how divergences work.
Being very uncommon, divergences are very easily identified by anyone involved in trading or even has a basic knowledge of it. They are critical indicators of the change in the direction of the stock trend or market situations. While the trendsetters will take measures to control risk, speculative traders will look for a potential reversal trade opportunity. Through this article, one can understand the basic of trading divergences and learn how to study the line market for divergences, using technical indicators beyond RSI (Relative Strength Index)
Extreme refers to the highest and the lowest values estimated by the peaks and valleys in a graphical representation of the market prices. It is stated that those that matter the most occur in the extreme ranges. The RSI used in the above representations was extreme when it was either above 70 or below 30.
There can be two cases in the case of Divergences in the extremes. A bearish divergence can occur when RSI is in the upper case, i.e., above 70. In this situation, bullish investors will try to cover their positions in the market closely. And if the bullish divergence occurs with RSI in the lower extreme, i.e., below 30, bearish or short, investors will work towards controlling their risk and market exposure more closely.
What are the alternatives to using the RSI?
RSI is only one of the few indicators that help to understand the market situation. RSI uses the standardized extreme range approach to ascertain the divergences, which is not in the case of other technical indicators. With extreme ranges, it becomes convenient to understand these signals. But that doesn’t mean that the trader cannot expect the same kind of convenience with other indicators.
RSI oscillates within a fixed range of 1-100 (including the extremes). Simultaneously, some of the preferred oscillators such as MACD, CCI, or stochastic do not work in a constrained range. In this situation, it is advised to look at recent history and discover the divergences when these oscillators reflect highs and lows beyond their normal range.
In the below chart, RSI sets higher lows(1) in the lower extreme while the market shows lower lows. This is clearly the case of a bullish divergence. The same signal can be seen on CCI. Here, it is hitting more extreme lows (2) compared to recent history. Similarly, it is also evident in the MACD (3). This is because it extends below its current range.
All the indicators will show similar results when applied to the same situation. This is because the information used in all the oscillators are quite similar, and the ways to calculate these signals are also very similar. It all depends on the personal preference of the trader, which indicator he is more convenient with. They may stick to RSI or may choose another oscillator like MACD or CCI.
You can learn to find this pattern using previous data. Try to notice their appearance in the market’s current trend. You must think from a long-term trader perspective to give a finishing touch to your trading game plan.
Divergent oscillators provide the traders with the strongest indicators of the market’s future and its speed. When Roc and momentum are combined with these evident divergences, the traders can calculate the most likely moment when the market will shift the direction.