Different Types of Divergences with Live Trading Examples

 

Hello dear readers, accurately forecasting the direction of price movements in advance is what everyone who participates in financial market trading hopes for. To achieve this, an understanding of both technical and fundamental analysis is necessary. Technical analysts participate in trading using various strategies, and one of these strategies incorporates the concept of "divergence". When we talk about divergences in the Forex market, we refer to a situation where there is a contrast between price movement and a technical oscillator. In other words, in technical analysis, divergence indicates the disparity between a price chart and a corresponding indicator or oscillator’s movement. Such divergences are considered possible signs of a reversal in the current price trend, suggesting a likelihood that the trend might not continue. Divergences usually occur at times when price changes slow down and are seen as signs of a possible reversal. There are three types of divergences based on two main categories.

Main Categories of Divergences

Divergences in two main categories arise from the movement of lines on the price chart compared to the lines on the oscillator. These are the following divergences:

 a) Bullish Divergence or Positive Divergence. When the price chart is decreasing while an oscillator or indicator is rising, this is referred to as positive or bullish divergence. This indicates that the current downward trend might weaken and an upward reversal could be approaching. In this type of divergence, the focus is on the bottoms.

The Types of Divergences

 b) Bearish Divergence or Negative Divergence. When the price chart is rising while an oscillator or indicator is falling, this is known as negative or bearish divergence. It indicates that the current upward trend could weaken, suggesting a possible downward reversal. Peaks are generally considered in this type of divergence.

No matter which type of divergence it is, there are certain aspects we need to be aware of. Therefore, when plotting divergences on the chart, we should pay attention to the characteristics of the indicator we are using. For instance, the Relative Strength Index (RSI) indicator considers candle closes, so when drawing divergence lines on the price chart, we do not take the candle shadows into account.

Different Types of Divergences

As mentioned earlier, divergences signify a disparity between a price chart and an indicator or oscillator in technical analysis. These differences play a role in estimating the chances of a trend either continuing or not. There are various types of divergences, and they are as follows:

1. Regular Divergence (Standard Divergence)

Standard divergence, also known as "normal" or "classic" divergence, is a term frequently used in technical analysis to describe the inconsistency between price movement and an indicator. This type of divergence occurs when the price moves in a certain direction while the technical indicator being used (e.g., RSI, MACD, or Stochastic Oscillator) moves in the opposite direction. An example of this divergence is when the price rises while the indicator falls, or when the price falls while the indicator rises. Regular divergence denotes the traditional disparity between a price chart and an indicator or oscillator. There are two types of standard divergence:

Bullish(or Positive) Regular Divergence: Standard bullish divergence occurs when the price makes lower lows while the indicator makes higher lows, which can be a sign that the downtrend may be ending and an upward trend may be starting. If the indicator rises while the price falls, it is interpreted as a possible bullish signal. In other words, while the price makes lower lows, the indicator makes higher lows. This situation indicates that the strength of buyers is increasing and the current downtrend may be about to end. Bullish divergence can be considered a buy signal for traders. Take a look at the example of the Gold/US Dollar chart.

Regular Divergences in the XAU/USD chart

Bearish(or Negative) Regular Divergence: Standard bearish divergence occurs when the price makes higher highs while the indicator makes lower highs, indicating that the uptrend may be ending and a downtrend may be starting. In other words, when analyzing the chart, if the price makes higher highs and the indicator makes lower highs, this situation may signal that the uptrend is about to end and a new downtrend is imminent. When the price is increasing while the indicator is decreasing, it implies a possible signal for an upcoming decline. See example on the Spot Gold/US Dollar 4-hour chart above.

2. Hidden Divergence

Hidden divergence shows the differences between the movements in the price chart and oscillators. It is particularly used to predict trend reversals and continuations. Oscillators, often known as momentum indicators, are used to determine the strength and direction of price movements. Hidden divergence provides signals that a trend is likely to continue. When a hidden divergence occurs between the price chart and the indicator or oscillator, the likelihood of the current trend continuing increases. There are two types of hidden divergence:

Bullish (Positive) Hidden Divergence: Hidden bullish divergence occurs when the price chart makes a higher low while the oscillator makes a lower low. As the price forms higher low points from previous lows, if the indicator or oscillator shows lower low points, this scenario reflects the probable continuation of the existing trend. It’s a signal of a period where the price could reach higher levels. Refer to the example on the EUR/USD chart.

Hidden Divergences in the EUR/USD chart

Bearish (Negative) Hidden Divergence: Hidden bearish divergence occurs when the price chart makes a lower high while the oscillator makes a higher high. This indicates that the current downtrend is likely to continue. As the price creates lower high points from previous highs, if the indicator or oscillator displays higher high points, this situation reveals the weakening of the current trend. It’s a sign of a period where the price could decline in the short term. An example on the EUR/USD chart above illustrates this.

Hidden bullish divergence indicates that buyers are maintaining their strength and prices may rise again. Hidden bearish divergence, on the other hand, shows that sellers are still strong and prices may start to fall again. Hidden divergences indicate the likelihood of trend continuation and are usually used as a sign that the current trend will continue during a pullback phase.

3. Exaggerated Divergence

Exaggerated divergence occurs when there is a more pronounced and often horizontally defined discrepancy between the price and the oscillator. This type of divergence is interpreted similarly to standard divergences but provides a clearer signal. Exaggerated divergence indicates specific differences between price movements and oscillators and is used to identify market reversals. This term is less commonly used and is sometimes referred to as "Hyperbolic Divergence". Exaggerated divergence is a type of divergence that becomes more apparent than usual. The discrepancy between the price chart and the oscillator becomes so pronounced that it is considered a stronger signal that the trend may reverse.

Bullish (Positive) Exaggerated Divergence: While the price forms the equal low points, the indicator (oscillator) shows higher low points, or conversely, the indicator forms the same low points while the price forms lower lows. See the EUR/GBP chart below.

Exaggerated Divergences in the EUR/GBP chart

Bearish (Negative) Exaggerated Divergence: As the price creates the equal high points, the indicator (oscillator) displays lower high points, or conversely, the indicator forms the same high points while the price forms higher highs. See the EUR/GBP chart above.

Both Positive Exaggerated Divergence and Negative Exaggerated Divergence can be considered significant signs of a trend reversal. All types of divergence are used in technical analysis to aid in predicting price direction or changes in trend.

These types of divergences provide valuable information for traders using technical analysis tools and can be a powerful tool for making forecasts about market movements when interpreted correctly. All divergences in technical analysis can also reflect the emotional and psychological states of market participants, so understanding market sensitivity is critical for predicting future price movements.

It’s important to remember. While the Forex market offers substantial opportunities, it also comes with high risks, which means there’s a possibility of losing our capital. When making trading decisions, we should carefully research, learn to manage risks, and experience different strategies. We should be aware that divergences are just one component in trading and might not always yield accurate results. When evaluating signals using tools like divergences, we must always be sensible and cautious. By combining risk management with emotional control and staying up-to-date with information, we can seize more successful trading opportunities in financial markets. Trade wisely, get good results!