Divergence Indicator: Enhance Your Trading Strategy
This article will guide you through the information on Divergence, what it is and how to use it in trading.
Definition of Divergence in trading
The term “Divergence” refers to a discrepancy or difference between the price movement of an asset (such as a stock, currency pair, or commodity) and a related indicator or another asset. Divergence is often used by traders to identify potential reversals or shifts in the direction of the price trend.
Divergence provides information on market momentum, and it’s a highly-reliable signal that the current price trend could be weakening. This could mean that a change in market price direction is coming
Besides, Divergence can suggest a possible Uptrend/Downtrend. Negative divergence is when the price is in an Uptrend, but the indicator is going down or giving bearish signals. On the other hand, when the price is going down, but the indicator is going up or showing signs of a bullish signal, it’s called positive divergence.
Since divergence doesn’t always happen when prices change direction and can take a while to show up, it’s not something you should solely count on to predict reversals. To make sure you’re making good trading decisions, it’s important to use other different tools like trendlines and support/resistance zones. This can help back up your decisions and make them more reliable.
Market price momentum explained
The way the market price goes Upward and Downward tells us how strong its momentum is. When prices move really steeply and for a long time, it means they have a lot of energy, which is called strong momentum. On the other hand, when prices move gently and don’t go very far, it means their energy is weak, called weak momentum.
When the upswings are longer, it means the momentum is strengthening. Shorter upswings show that the momentum is weakening. If the upswings are all the same length, it means the momentum hasn’t changed.
Momentum indicators are commonly used to smooth out choppy price action and provide a better visual of price swings. Rather than only having to compare price movements, traders can compare the indicator swings to price swings using momentum indicators.
Divergence can tell us important things about how to manage trades. Divergence amount varies, so the relationship between the price and an indicator could show several patterns.
Even though divergence shows that there are some ongoing changes, it doesn’t necessarily guarantee that the trend will completely reverse. Instead, it’s a signal for traders to consider their next steps carefully: holding onto the investment, using a strategy like selling a covered call (selling an option to buy while also having the asset), adjusting the stop loss, or deciding to sell the asset.
Remember, the key to making money in trading is to choose the right plan based on what the prices are actually doing, not just what you think they might do.
Using momentum is useful when trends are strong and active, but it may not be as effective during range-bound conditions where prices move within a confined and unpredictable range.
The path to successful trading involves using the right strategy based on how prices are moving. Some common types of momentum indicators used to measure price movements are:
- Relative strength index (RSI);
- Stochastic oscillator;
- Moving average convergence divergence (MACD);
- Rate of Change (ROC).
Types of divergence
There are two main types of divergence in trading:
Regular divergence occurs when the price of an asset moves in one direction (up or down), while a related indicator moves in the opposite direction. This can be an early sign that the current price trend might be losing momentum and a reversal could be on the horizon. Regular divergence is further divided into two types:
- Bullish Divergence: Bullish divergence occurs when the price is making lower lows (going down) while the indicator is making higher lows (going up). This suggests that the downward momentum is weakening, and a potential bullish reversal might be coming.
- Bearish Divergence: Bearish divergence occurs when the price is making higher highs (going up) while the indicator is making lower highs (going down). This indicates that the upward momentum is weakening, and a potential bearish reversal might be approaching.
2. HIDDEN DIVERGENCE:
A hidden divergence occurs when the price is moving in one direction, and the indicator is moving in the opposite direction, but the indicator’s movement is in the same direction as the larger trend. Hidden divergence often suggests that the current trend is likely to continue.
- Hidden Bullish Divergence: Hidden bullish divergence happens when the price is making higher lows, while the indicator is making lower lows. This can indicate that an uptrend is likely to continue.
- Hidden Bearish Divergence: Hidden bearish divergence occurs when the price is making lower highs, while the indicator is making higher highs. This can suggest that a downtrend is likely to persist.
Traders use divergence patterns as signals to identify potential trading opportunities. However, it’s important to note that divergence is not foolproof and should be used in conjunction with other technical analysis tools and indicators to make informed trading decisions.
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