Divergence Trading

  • August 28, 2020

“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 are talking about divergence, we're talking about what happens when price continues to make higher highs in a bull trend.  

However the indicator values do not follow price. On the contrary, it happens when 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. 

Two Common Divergence Trading Indicators:

  • The Relative Strength Index (RSI) and Commodity Channel Index (CCI) are two of the most common indicators utilized to spot divergences. These are both momentum indicators, so it isn’t necessary to use them both at the same time. 

RSI is a type of momentum oscillator displaying values between 0 and 100; very often used to determine trend weight as well as overbought and oversold price levels. Overbought is typically any level over 70, while oversold is typically any level below 30. 

Keep in mind that, when being 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 type of momentum oscillator displaying values between -300 and +300.

The primary use of these indicators is to measure the strength and weakness of any given trend. But they have an alternative use, which is spotting divergences that create some great trading opportunities. 

1.Why Bother Spotting 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.

Ever been in a green trade but price refused to hit your profit target? You probably wondered if it was a good time to get out or 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.

Ever stared at the tape and thought it looked like buyers were running out of energy despite price slowly grinding up? Divergence can provide a level confirmation with this theory.

Perhaps 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.

2. Boiling It Down With Two Chart Examples:

Divergence Trading

TSLA 5m Bearish Divergence - August 19, 2020 (Figure 1)

In the above 5m TSLA chart, we can see 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 provides bears with an alert to begin looking 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, as well as 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 at the same time on your charts. These are both momentum indicators and will almost always move together. Using them both would be like driving a car with 2 gas pedals; completely redundant right? This example is just to show you that you can use either one you prefer.

3. More Examples Spotting Divergence Trades Using $AAPL

With divergence trading, its 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.

Divergence Trading

AAPL 5m Bearish Divergence - August 19, 2020 (Figure 2)

Trading Divergence = The Land of Golden Opportunity? 

  • 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 that don’t particularly enjoy staring at several monitors for too long.
    As we are all very aware, the 2020 pandemic outbreak led to some historic market volatility that will undoubtedly be talked about for decades to come. 
  • It was impossible to anticipate an outbreak of an infectious disease, but weakness in the market was VERY evident.
    For those of you that are members of the Bullish Bears Facebook Group, you can a detailed post on the “evident weakness” matter by checking this post,

    Divergence was one of the many cues providing hints that something was going to give out prior to the drop in January/February 2020…

William fullbright

-FORMER US SENATOR-

There is an inevitable divergence between the world as it is and the world as men perceive it.

Before the pandemic selloff, the market was essentially more bullish than at any point in history. Massive economic growth was projected for 2020, and that reflected in the clear strength of buyers.

But we can see that CCI failed to make new highs from the January peak, while $SPY (an ETF that tracks the S&P 500) continued to rally into mid-February. (See SPY Daily Figure 3 below)

For the long term investor, this divergence served as a warning to implement some hedges or reduce exposure by taking some profits; perhaps even begin to look for some discount deals once the market found its bottom.

For the more aggressive swing trader, the ideal short position was at the loss of the marked 161.8% Fibonacci trading Extension.

SPY Daily (Figure 3)

Divergence Trading From The Wrong Side of Price

Hopefully, you can now see why trading divergence can be a helpful technique with 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.

Always 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 it’s wise to wait for a better opportunity. Patience can be a trader’s greatest virtue!

“The man who is a master of patience is a master of everything else.” -George Savile

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