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‘In vector calculus, divergence is a vector operator that measures the magnitude of a vector field’s source or sink at a given point, in terms of a signed scalar. More technically, the divergence represents the volume density of the outward flux of a vector field from an infinitesimal volume around a given point.’ – Wikipedia
Lucky for you that’s not what we are talking about…Relax!
The definition of ‘Divergence” from Investopedia is much more relevant:
‘When the price of an asset and an indicator, index or other related asset move in opposite directions. In technical analysis, traders make ..decisions by identifying situations of divergence, where the price of a stock and a set of relevant indicators, are moving in opposite directions.’
So for our purposes, divergence is when the price of a currency pair moves in the opposite direction to the underlying indicator/index, such as the RSI or Stochastic. Simple right? So for example; the price action may be trending lower (making lower lows), and the RSI is making corresponding higher lows, or trending higher. The RSI is diverging from the price action, i.e. divergence.
There are basically 2 types of Divergence.
- Reversal Divergence.
- Continuation Divergence.
The most commonly recognised form of divergence is Reversal Divergence. This can appear as either Bullish Divergence, if you are looking at base of the bars and indicators and hence buying, or Bearish Divergence, if you are looking at selling, and hence the top of the price bars and indicators.
Bullish Reversal Divergence
Bullish divergence occurs when, during a downtrend, price makes a lower low but the indicator makes a higher low. This essentially indicates the strength of the selling has decreased and hence there is potential for a reversal in price. A bullish move or buying opportunity.
Bearish divergence occurs when, during an uptrend, price makes a higher high, but the indicator makes a lower high. This indicates that the strength of the buying has decreased and hence there is potential for a reversal in price. A bearish move or a selling opportunity.
Reversal Divergence is generally used as a potential signal that a trend may be coming to an end or at least a pullback maybe about to occur. Potentially time to take profit! End of phase 1.
Continuation Divergence is often referred to as ‘Hidden’ Divergence. Why Hidden? I don’t know. Possibly as it’s harder to find ? Or because the next potential move is hidden? Who cares. What’s important is that it tells us there’s a strong indication that the price will continue to move in the direction of the prevailing trend!
Bullish Continuation Divergence
Bullish Continuation Divergence occurs when the price action makes a higher low, but the indicator makes a lower low. This indicates that basically after strong selling in the market, the underlying trend is higher and there is potential for a continuation move higher. A bullish buying signal.
Bearish Continuation Divergence occurs when price makes a lower high, but the indicator has made a higher high. Despite strong buying, the underlying trend is lower and there is now a potential for a continuation move lower. A bearish selling signal.
Recognising divergence becomes somewhat of an art. It’s generally not something as a trader you go looking for. It’s more something you just recognise and then add to your overall picture or analysis of the market. It’s an additional indicator to add to your arsenal!