Divergence trading is a phrase you’ve probably heard a few times if you’re new to trading and countless times if you’re experienced. When we talk about divergence, we’re talking about what happens when the price continues to make higher highs in a bull trend.
However, the indicator values do not follow the price. On the contrary, it happens when the price continues to make lower lows, but the indicator values make higher highs. Get it? Don’t worry; we’ll explain with some examples below.
The Relative Strength Index (RSI) and Commodity Channel Index (CCI) are the most common indicators for spot divergences. These are both momentum indicators, so it isn’t necessary to use them simultaneously.
RSI is a momentum oscillator displaying values between 0 and 100; it is often used to determine trend weight and overbought and oversold price levels. Overbought is typically over 70, while oversold is below 30.
Remember that, when used properly, these overbought and oversold levels are not directly used as trading signals. They are not a “one size fits all” value and will usually differ between products. Some products may reverse at a reading of 60, and others at higher extremes such as 90.
CCI is also a momentum oscillator displaying values between -300 and +300.
The primary use of these indicators is to measure the strengths and weaknesses of any given trend. But they have an alternative use: spotting divergences that create great trading opportunities.
Why Spot Divergence In Trading?
Divergence-based trading systems are typically utilized when trying to generate trading opportunities at anticipated reversal price levels, as well as for confirmation of continuation probability.
Have you ever been in a green trade, but the price refused to hit your profit target? You probably wondered if it was a good time to get out or if it would be better to hold through the storm. Divergence can tell you that the trend is weakening, and it might be time to get out. It’s the hidden hand of weakness or strength.
Have you ever stared at the tape and thought it looked like buyers were running out of energy despite the price slowly grinding up? Divergence can provide a level of confirmation with this theory.
Perhaps the price is extended far from the mean, and you’re looking to catch a position based on a mean reversion setup; in this situation, divergence can give you hints as to when it’s time to sit it out or begin searching for a point to pull the trigger.
Divergence Trading Example
TSLA 5m Bearish Divergence – August 19, 2020 (Figure 1). The above 5m TSLA chart shows the price traded in a narrowing channel (an ascending wedge pattern) for a large portion of the session. RSI/CCI showed declining strength, AKA Divergence (marked by the green line), a warning of impending correction or reversal.
This provides bulls with plenty of clear clues. From this divergence, a bull with no active position knows now isn’t the time to buy. A bull with an active position knows it’s time to reduce exposure or take profits completely. It also alerts bears to look for a mean reversion short trade, especially on larger time frames.
An optimal short entry was available at the marked point in the TSLA chart; this was a break of the trend line and a psychological support level of 1900. An easy profit target would have been the top of the 5m Opening Range.
Again, it’s important to remember that it’s not necessary to use CCI and RSI on your charts simultaneously. These are both momentum indicators and will almost always move together. Using them both would be like driving a car with two gas pedals; completely redundant, right? This example shows you that you can use either one you prefer.
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With divergence trading, it’s all about confirmation. In this 5m AAPL chart below, we can see that, after a strong opening, Apple went into a descending triangle pattern, which is most often considered a bearish formation.
CCI also clearly formed a divergence trend, as marked by the green line, a warning that buyers were running out of energy. This is a great pattern for scalpers to nibble on the tops and bottoms. It’s also a good opportunity for trend traders to catch the breakouts or breakdowns of the support and resistance lines.
In nearly the same scenario as the last example, this divergence warned long traders to sit it out, reduce exposure, or exit entirely.
As we can see from the marked point, we got a solid breakdown of the support level from the pattern, which offered a low-risk short entry for the bears.
AAPL 5m Bearish Divergence – August 19, 2020 (Figure 2)
So, we know what Divergence looks like on the smaller intraday time frames. But what about the larger time frames? After all, not everyone is a day trader. Many of us are swing traders who don’t particularly enjoy staring at several monitors for too long. We are all very aware that the 2020 pandemic outbreak led to some historic market volatility that will undoubtedly be discussed for decades.
It was impossible to anticipate an outbreak of an infectious disease, but weakness in the market was VERY evident. For those of you who are members of the Bullish Bears Facebook Group, you can find a detailed post on the “evident weakness” matter by checking this post. Divergence was one of the many cues providing hints that something would give out before the drop in January/February 2020…
Hopefully, you can now see why trading divergence can be a helpful technique for adjusting your position sizing, reducing risk, and identifying clear trading opportunities. Indeed, it can help you stay on the right side of price action on many time frames, small and large.
Remember that nothing is 100% in the markets, and hindsight is 20/20. When identifying divergence opportunities, try to keep it clear and concise. The setup should be practically screaming at you through your trading desk.
If it isn’t crystal clear, there’s probably not a good setup, and waiting for a better opportunity is wise. Patience can be a trader’s greatest virtue!
“The man who is a master of patience is a master of everything else.” – George Savile.