If you want to become a successful stock trader, one of the things you need to know is when to enter or exit a trade. This isn’t always easy, but you can use a technique called divergence trading to make better decisions. Trading divergences can help you become a consistently profitable trader because you’ll often buy near the bottom and sell near the top, which reduces your risks and increases your potential profits. Check out this comprehensive guide to learn what divergence is in stocks and how to trade divergence properly:
What Is a Divergence in Trading?
A divergence occurs when an asset’s price is moving in one direction and an indicator is moving in a different direction. In general, if the price is rising and making higher highs but the indicator is making lower lows, there’s a divergence. A divergence suggests that the current price trend is showing signs of weakening and may cause the price to change direction. It can happen between the price of an asset and almost any indicator.
A price divergence can be positive or negative. A positive divergence is an indication that the price of an asset may move up, while a negative divergence signals that the price is likely to fall. However, it’s important to note that divergence shouldn’t be relied on solely when executing a trade because it may not provide timely trade signals. It can go on for a long time without the occurrence of a price reversal.
Types of Divergence in the Stock Market
There are two types of regular divergence and two types of hidden divergence. While a regular divergence signals a reversal of the price trend, a hidden divergence indicates that the trend will persist. Below are the four forms of divergence in stock trading:
- Bearish divergence: A bearish divergence occurs when the price is making higher highs while your preferred indicator is giving you lower highs. It usually leads to the price making a rapid bearish move.
- Bullish divergence: A bullish divergence is the opposite of a bearish divergence. It happens when the price is creating lower lows while the indicator is showing higher lows, suggesting that the price should be on an upward trend.
- Hidden bearish divergence: There’s a hidden bearish divergence when the price is making lower highs and the indicator is creating higher highs. It means that the trend should remain on the downside.
- Hidden bullish divergence: A hidden bearish divergence occurs when the price is creating higher lows while the indicator is showing lower lows. In this case, the trend is likely to stay on the upside.
Commonly Used Stock Divergence Indicators
In order to accurately identify divergence in stocks, you need to know how to use an indicator. There are many indicators at your disposal, each of which has its own pros and cons. It’s up to you to decide which indicator is most suitable for your trading style. The following are four commonly used stock divergence indicators:
MACD is the acronym for Moving Average Convergence Divergence. It consists of a faster line and a slower line that can intersect one another, as well as a zero line. When using this indicator, you have to look for the moment when the faster line crosses the slower line.
If the fast line crosses the slow line in an upward direction, it’s a sign of a bullish divergence. Conversely, if the fast line crosses in a downward direction, you have a bearish divergence. A bullish signal occurs when the MACD line is going up while the price is going down. If the MACD line is going down and the price is rising, it’s an indication of a bearish divergence.
RSI stands for Relative Strength Index. It’s an oscillator indicator with one line that fluctuates in three different areas. These areas are the oversold area below the 30 line, the overbought area above the 70 line, and a neutral area between the 30 and 70 lines. If the RSI line crosses the 70 mark into the overbought zone, you have a sell signal. On the other hand, if the line falls below the 30 mark into the oversold area, it gives you a buy signal.
As a member of the oscillator indicator group, the Stochastic indicator works in the same way as the RSI indicator. This indicator has two lines that fluctuate in different areas on a chart that ranges from 0 to 100. These areas include the oversold zone below the 20 line, overbought zone above the 80 line, and a neutral zone between the oversold and overbought zones. A sell signal occurs when the two lines rise above the 80 line, while a buy signal is shown when the lines dip below the 20 line.
CCI, or Commodity Channel Index, was developed as a commodity trading indicator, but it’s now widely used in stock trading as well. It’s a simple indicator that consists of an indicator line, zero line, and overbought and oversold areas. The CCI indicates that the price of an asset is above the historic average when it’s above zero and below the historic average when it’s below zero. If the indicator line rises to above 100, it gives a sell signal. Conversely, if it falls below -100, it shows a buy signal.
How to Trade Divergence
Knowing how to identify divergence in the stock market can help you make better buying and selling decisions. It enables you to gain a better understanding of the underlying momentum in an asset’s price and assess the possibility of a price reversal. Learning how to read indicators is the first step to successful divergence trading, but it isn’t enough. You also have to know certain tips and tricks in order to take full advantage of divergence in stocks. Follow these strategies to become a more effective divergence trader:
Understand that Divergence Isn’t Confirmation
As mentioned earlier, you should avoid making buying and selling decisions based on divergence alone. Instead, you have to use a variety of other criteria and tools to confirm a trade. A divergence takes place when an asset’s price and your indicator are telling you different things, while a confirmation occurs when the price and the indicator or multiple indicators are showing the same thing. Ideally, you should achieve confirmation before you enter or exit a trade. If you see that the price is rising, you want your indicators to show that it’s likely to keep going up.
Bear in mind that divergence only indicates a loss of momentum, but it doesn’t necessarily signal a trend shift. Acting on divergence alone can lead to substantial losses if the anticipated price reversal doesn’t occur soon enough or at all. Many traders have gotten bad results when they trade with divergences only. Similar to other trading strategies, you should try to get a stronger confirmation by adding more confluence factors.
Enter a Trade at the Right Time
When you see a divergence on the chart, it’s important that you don’t jump hastily into the trade. You should wait a while to see whether the price action will confirm the signal. Confirmation usually occurs when the price goes beyond the trend line, which is an indication of a reversal. Another good entry point is when the price breaks resistance or support. Once you see either of these entry signals, you should use it as an opportunity to place a trade.
Use a Stop Loss Order
Using a stop loss order can help you prevent an unpleasant surprise when the market moves against your trade. The best place to set your stop loss order is above the top or below the bottom the reversal has created. In theory, if you managed to spot a new trend when it was starting out, you should make sure the previous swing point won’t be breached.
Set the Right Profit Target
There are many profit target methods you can use to get better results from divergence trading. One of these methods is to create trend lines on your chart. As long as the price doesn’t break the trend line, you can just stay in the trade. Alternatively, you can watch out for the moment when a stock starts to create higher lows or lower highs. This is a sign that a new divergence may be developing, which is moving in the opposite direction from your position.
Now that you know what is a divergence in trading, you have another tool that can help you become a successful trader. However, you need to exercise caution when you’re trading divergences because they can produce false signals, especially in trending markets. Since almost every indicator is derived from price and volume data, you should base your trading decisions on price movements and then use indicators to confirm your decisions, not the other way round.