Although divergence is not an indicator in that it is not mathematical construct, it is often said to be a leading indicator, hence its inclusion in this section.
Modern chart technicians talk of two types of divergence: regular divergence and hidden divergence.
Regular divergence is the classic sense of divergence that occurs when the price action makes higher highs or lower lows while the oscillating indicator fails to match the higher highs or lower lows. This indicates a real weakness in the price action and an early warning that the trend is losing momentum and could be coming to an end. In other words, regular divergence indicates that a probable trend reversal could occur through it does not indicated when this will occur. For this reason chartists often turn to trend lines, chart patterns and candlestick patterns to time the entry into the trade.
Regular divergence can be either positive (bullish) or negative (bearish).
- Positive Divergence is bullish and occurs in a down trend when the price action prints lower lows that are not confirmed by the oscillating indicator. This indicates a weakness in the down trend as selling is less urgent or buyers are 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 RSI and the Stochastic Oscillator that are range bound and less often on oscillators such as MACD and CCI that are not range bound.
- Negative Divergence is bearish 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 is less intense and selling or profit taking is increasing. As with positive 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.
Hidden divergence occurs when the oscillator makes a higher high or a lower low while the price action does not make a higher high or a lower low. 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 oscillator makes a higher high while the price action does not as it is in a correction or consolidation phase. 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 be last long. Thus, the uptrend can be expect to resume.
- Bearish Hidden Divergence occurs during a reaction in a down trend when the oscillator makes a lower low while the price action does not as it is in a reaction or consolidation phase. 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.
Neither regular nor hidden divergence gives clear entry signals. Instead they respectively give an indication of the weakness or strength 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 trend lines, 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.
Thus, negative (bearish) divergence is quite significant when it occurs near or at a resistance trendline, or when a bearish reversal pattern occurs in an uptrend; and positive (bullish) divergence becomes quite significant when it occurs near or at a support trendline, or when a bullish reversal pattern occurs in a down trend.