What Is the Best Divergence Trading Strategy?
Key Questions Answered
Divergence is a trading phenomenon that offers reliable and high-quality information regarding trading signals. It refers to when an asset’s price moves in the opposite direction to the momentum indicators or oscillators. Commonly used indicators include the relative strength index (RSI), stochastic oscillator, Awesome Oscillator (AO), and moving average convergence divergence (MACD).
What Is Divergence?
Divergence is one of the many concepts that experienced traders use to time when to enter or exit the market. To say a divergence occurs is to say that the price and momentum are out of sync. This signals that the market is preparing for a trend reversal or pullback, but it does not necessarily guarantee trend directions.
There are mainly two types of divergence:
- Regular divergence is where the price signal creates higher highs or lower lows while the indicator makes lower highs or higher lows respectively.
- Hidden divergence, which is the opposite of regular divergence, is where the indicator makes higher highs or lower lows while the price action creates lower highs or higher lows respectively.
Regular Divergence vs. Hidden Divergence
Regular divergence is especially useful for cautiously predicting trend reversals, while hidden divergence can indicate trend correction or continuation.
Differences between regular and hidden divergence (Source: Trading Setups Review)
There is also a third, less-common type of divergence — extended divergence, which is very similar to regular divergence. The difference is that the price action forms double bottom or double top patterns. In short, a double top pattern forms the letter M while a double bottom forms the letter W.
Double top and double bottom extended divergence patterns (Source: BabyPips)
What Is Regular Divergence?
Regular divergence can be divided into two types: regular bearish divergence and regular bullish divergence.
What is Regular Bearish Divergence?
- Regular bearish divergence occurs when the price action makes successively higher highs while the indicator makes consecutively lower highs. This suggests that the asset’s price is preparing for a reversal into a downtrend. The indicator signal means that the momentum is changing. Even though the price action has made higher highs, the uptrend may be weak. In this scenario, traders should get ready to go short, i.e., to sell the asset and repurchase it later at a lower price.
What is Regular Bullish Divergence?
- Regular bullish divergence happens when the price action forms progressively lower lows while the indicator creates higher lows. This implies that the prices will move in an upward trend soon. The indicator action implies that the price needs to catch up with the indicator signal and that the downtrend is weak. In this scenario, traders should get ready to go long, i.e., to buy the asset.
How to Identify Regular Divergence?
Traders observe price action and use trading tools like momentum indicators to identify divergences. Most cryptocurrency exchanges and pricing websites support adding indicators into the price chart to facilitate price movement analysis.
There are generally two types of indicators: leading and lagging indicators. Leading indicators predict a market’s future direction while lagging indicators confirm the price movement that is taking place or has already passed.
What are the Leading Indicators?
One of the most popular leading indicators is the relative strength index (RSI), which traders use to identify whether an asset is overbought or oversold. The RSI is a calculation of the average upward price change relative to the average downward price change, reflected as a percentage. The figure below shows an example of a regular bearish divergence identified using the RSI. From the figure you can see that the price makes consecutive higher highs while the RSI makes successive lower highs.
Regular bearish divergence identified from a Bitcoin price chart from January 26 to June 17, 2021, 1D time frame with the RSI (Source: TradingView)
The stochastic oscillator is another popular leading indicator, and was first introduced by George Lane in the 1950s. Traders use the stochastic oscillator to compare an asset’s recent closing prices to a range of its prices over a certain time frame. In the figure below, the stochastic oscillator is used to identify a regular bearish divergence. The figure shows the price movement forming progressively higher highs while the stochastic oscillator forms progressively lower highs.
Regular bearish divergence identified from a Bitcoin price chart from April 19 to October 7, 2015, 1D time frame with the stochastic indicator (Source: TradingView)
What are the Lagging Indicators?
The moving average convergence divergence (MACD) is an indicator based on the moving averages (MA) that traders use to identify when to enter or exit a market. The MACD involves three components — two MAs and a histogram. Since the MA is a lagging indicator, the MACD is generally regarded as one as well. However, the MACD is sometimes considered a leading indicator, as traders can use the histogram to predict signal crossovers between its two moving averages. The figure below depicts an example of a regular bearish divergence identified by the MACD. The figure shows the price action forming progressively lower lows while the MACD forms progressively higher lows.
Regular bullish divergence identified from an Ethereum price chart from May 1 to October 16, 2017, 1D time frame with the MACD (Source: TradingView)
Another lagging indicator is the Awesome Oscillator (AO). It compares recent price movements to previous price movements to determine whether the market is in a bullish or bearish trend. The AO is based on two simple moving averages (SMA), and can indirectly be considered a lagging indicator. In the figure below, there is an example of a regular bullish divergence identified using the AO. The figure shows the price forming progressively lower lows while the indicator forms progressively higher lows.
Regular bullish divergence identified from a Bitcoin price chart from May 8 to September 14, 2017, 1D time frame with the Awesome Oscillator (Source: TradingView)
How to Trade Regular Divergence?
Divergence only tells traders that the momentum of a price movement is weakening. This does not necessarily lead to a strong reversal, and the price movement may just be entering a sideways trend (horizontal price movement within a stable range). To create a more reliable divergence trading strategy, skilled traders combine indicators with various tools. One popular tool is the exponential moving average (EMA) chart, which gives more weight to the most recent prices.
Regular bullish divergence and regular bearish divergence have different entry rules. In any case, once a trader has spotted a divergence, they should consider how to enter or exit the market and place their Stop Loss or Take Profit orders. As the crypto market is volatile, the Stop Loss or Take Profit order should not be too close to the entry price, or else it will trigger too quickly. Traders should place Take Profit orders according to the reward-to-risk ratio, which is calculated as follows:
(Take Profit price – Entry price) / (Entry price – Stop Loss price) = Reward-to-risk ratio
Trading Regular Bullish Divergence
The figure below is an example of how to enter a market after the appearance of a regular bullish divergence. A 20-day EMA is used with the MACD to determine when to enter the market. The corresponding steps are as follows:
- The trader identifies a regular bullish divergence, where the price chart forms lower lows while the indicator action makes higher lows.
- The trader waits until the price closes above the 20 EMA chart (around $221 in this case). This will be the entry point.
- The trader places an order around the identified price point and prepares to go long.
- To limit losses, the trader places a Stop Loss order away from the previous swing low. In this case, the previous swing low is around $150, and the Stop Loss order is around $146.
- The trader places a Take Profit order. Depending on their risk tolerance, they should place the order somewhere that yields a reward-to-risk ratio of between 1.5 and 2. In this case, the Take Profit order is around $383, giving a reward-to-risk ratio of roughly 2.
The Take Profit, Stop Loss, and entry point for a regular bullish divergence identified from an Ethereum price chart from May 1 to October 7, 2017, 1D time frame with the MACD (Source: TradingView)
Trading Regular Bearish Divergence
The figure below is an example of how to exit a market after the appearance of a regular bearish divergence. A 20-day EMA is used with the RSI to determine when to exit the market. The corresponding steps are as follows:
- The trader identifies a regular bearish divergence, where the price movement creates higher highs while the indicator forms lower highs.
- The trader waits until the price closes below the 20 EMA chart (around $55,000 in this case). This will be the exit point.
- The trader places an order around the identified price point and prepares to go short.
- The trader places a Stop Loss order near the previous swing high. In this case, the previous swing high is roughly $64,000, and the Stop Loss order is placed higher at around $65,000.
- The trader should place a Take Profit order so that the reward-to-risk ratio is between 1.5 to 2. In this scenario, the Take Profit order is around $40,000 USD, which gives a reward-to-risk ratio of roughly 1.5.
The Take Profit, Stop Loss, and exit point for a regular bearish divergence identified from a Bitcoin price chart from January 26 to June 25, 2021, 1D time frame with the RSI (Source: TradingView)
Trading divergence can be very profitable if traders can reliably identify divergence by making use of the trading tools in their arsenal. However, like all trading strategies, using divergence indicators involves a certain degree of risk. Divergence is only a signal that indicates that the price’s momentum is changing, and does not guarantee a trend reversal or pullback. Traders are advised to understand the available trading tools and practice with such tools before utilizing them in trades.