How to trade bullish and bearish divergences

What is divergence?

A divergence is when the price of a currency pair moves in one direction and a technical indicator, usually an oscillator, moves in the opposite direction.

Divergence can indicate that the market has lost momentum and a slow down or reversal is coming. The direction of the divergence usually indicates whether the price movement’s change in momentum will be bullish or bearish, although the price reversal may occur immediately after the divergence or lag for an extended amount of time.

False positives, in which a price change does not follow a divergence, may also occur. So, it’s always a good idea to confirm trends with multiple indicators and use appropriate risk control when entering a position based on divergence.

Divergence vs reversal

While divergences can signal an impending price reversal, they do not always. Sometimes price action may slow from an up or down trend into sideways momentum following a divergence.

Understanding the possible outcomes following a divergence can help you decide whether to close or open a position or place a specific order. For example, because sideways momentum may occur after a divergence, it may be preferable to place a stop loss on your long position or limit order on your short position in case a price reversal does not occur. 

Divergence vs confirmation

While divergence occurs when the price and indicator display different information, confirmation describes when the price and indicator display the same information. Confirmation may also describe when multiple indicators show the same momentum.

Knowing how to read divergence helps traders enter or exit positions when confirmation is not available. However, price movement indicated by divergence may be delayed or a false positive, so traders should always confirm the divergence with other tools.

Types of divergence

There are three types of divergence: bullish (positive), bearish (negative), and hidden. Refer to the chart below for easy distinctions between them and read about each in more depth underneath.

What is a bullish divergence?

A bullish divergence occurs when the price makes lower lows but the indicator makes higher lows, hinting that the downtrend may soon reverse or at least slow to a sideways, range-bound pattern.

What is a bearish divergence?

Bearish divergences occur during an uptrend when the price is making higher highs but the indicator makes lower highs. This divergence signals that the price is likely to turn bearish and begin falling or at least turn sideways.

What is a hidden divergence?

Hidden divergences exhibit similar patterns as regular divergences, but the lower highs or higher lows occur in the price chart instead of the indicator. Hidden divergences indicate that the price trend will continue. Even though the price may seem to begin a reversal, the indicator continues to make higher highs or lower lows, giving credence that the change in price momentum is only a blip in the ongoing trend.

How to trade divergence

Because divergences occur before the price reversals they predict, traders can use divergences as leading indicators. Divergences can clue you in that a reversal may soon occur or that a run is coming to an end.

A bearish divergence may be a signal to close your position before it falls back on itself, or at least set a stop loss to protect your gains. Meanwhile, a bullish divergence indicates a possible entry point for traders before the price begins rising.

Recognizing divergences can help you sell high and buy low. The best part? Nearly any leading indicator can be used, as long as you know how to spot divergences.

Trade divergence with City Index

Build your volatility trading strategy in a risk-free environment with a City Index demo account.

Or, if you’re ready to start trading live markets, follow these simple steps to open your first position:

1.           Open a City Index account, or log in if you’re already a customer

2.           Search for the asset you want to trade in our award-winning platform

3.           Choose your position and size, and your stop and limit levels

4.           Place the trade

How to spot divergences

When looking to identify a divergence, you are watching both the price and your indicator of choice. You should look first at price action and whether it has been moving in any significant direction. Then, check your indicator below for peak formations signalling a divergence.

It may be helpful to draw a straight line on your chart connecting the peaks to see if a significant slope appears. You may also check for hidden divergence if you notice a higher low or lower high in the price chart.

There are many different indicators you can use to spot divergences. The examples below include the MACD, Stochastic Oscillator, and Relative Strength Index (RSI). 

MACD divergence

Moving Average Convergence Divergence (MACD) is a trend-following indicator that charts the relationship between two moving averages of a security’s price. It contains two lines and a histogram, all centred around zero. When looking for divergences, focus on the peaks of the histogram, as it averages the multiple averages plotted by the two lines.

The EUR/USD chart below shows a bullish divergence. The price chart shows lower lows while the MACD histogram displays a higher low for the same timeframe.

Stochastic Oscillator divergence

The Stochastic Oscillator shows the movement of the closing price relative to its high-low range, over a set period. One line tracks the closing price (blue) while another, smoothed line (red) represents a moving average of the relative close.

The Stochastic lines are bounded around zero. When they rise above 80 and outside of the shaded range, the market is indicated as overbought. When the Stochastic lines dip below 20 and underneath the shaded range, the market is indicated to be oversold.

In the chart below, the price of GBP/JPY makes a higher high, while the Stochastic Oscillator makes a higher low in the same period. This formation suggests the price is losing upward momentum and foreshadows a bearish reversal.

RSI divergence

The Relative Strength Index (RSI) measures the magnitude of recent price changes on a scale from 0 to 100 to identify when a market is overbought or oversold. When the RSI line rises above 70 or dips below 30, the market is indicated as overbought or oversold respectively.

A hidden bullish divergence is shown in the AUD/USD chart below. The price makes a higher low while the RSI charts a lower low. This divergence is considered hidden because the price chart features the diverging low while the indicator shows a continuation of lower lows.

How to trade with City Index

Follow these easy steps to start trading with City Index today:

1.           Open a City Index account, or log in if you’re already a customer.

2.           Choose a market (or markets) you want to trade in our award-winning platform.

3.           Choose your position and size, and your stop and limit levels.

4.           Place the trade.