Trading in the downtrend or reversals are considered as riskiest technique in Technical Analysis. But reversals can also be detected in a less risky way. Divergence is a very good technique to trade reversals in a less risky way and to pull out good chunk of money from trend reversals. Trend continuation can also be detected by Divergence.
When the price of an asset or security and an indicator index or other related asset move in opposite direction in the same range of time, then it is called divergence.
There are two types of divergence,
1. Regular Divergence
2. Hidden Divergence
3. Exaggerated Divergence
1. Regular Divergence:
This type of divergence detects trend reversals. Regular divergence can be Bullish or Bearish.When the price is creating Lower Low (LL) but indicator is creating Higher Low (HL) then it is Regular Bullish Divergence, indicates a strong possibility of trend reversal from downtrend to uptrend. It happens when a security or assets price is in downtrend but indicator is going upward as indicators have specific range for which it can not react with extreme falls so it react against the price trend which is a divergence.
Here is an example chart of Regular Bullish Divergence,
In the chart above, we can see that Price created Lower Low (LL) while indicator (MACD crossovers) created Higher Low (HL) which is a Regular Bullish Divergence. MACD bullish crossover after detecting divergence is a very good entry opportunity for buying.
When the price creates Higher High (HH) but indicator creates Lower High (LH) then it is Regular Bearish Divergence indicating trend reversal from uptrend to downtrend.
Here is an example chart of Regular Bearish Divergence,
In the chart above (BEXIMCO), price has created Higher High (HH) but MACD indicator created Lower High (LH) in its crossovers which is a Regular Bearish Divergence. After detecting divergence 2nd MACD bearish crossover can be treated as a strong sell signal.
2. Hidden Divergence:
Divergences not only detect a potential trend reversal but also the continuation of current trend. Hidden divergences can detect the continuation of the trend. When the price is making Higher Low (HL) but indicator is showing Lower Low (LL) then it is Hidden Bullish Divergence.
Here is an example chart of Hidden Bullish Divergence,
In the chart above, we can see that price created Higher Low (HL) while MACD indicator created Lower Low (LL) in its crossovers which is a Hidden Bullish Divergence which indicates that the uptrend will continue.When the price is making Lower High (LH) but indicator is showing Higher High (HH), then it is Hidden Bearish Divergence.
Here is an example chart of Hidden Bearish Divergence,
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In the chart above, we can see that price created Lower High (LH) but MACD indicator created Higher High (HH) between its crossovers which is a Hidden Bearish Divergence, indicates that the downtrend will continue.
3. Exaggerated Divergence:
It is similar to Regular Divergence. The difference between these two divergences is, in Exaggerated Divergence price creates double tops/bottoms or Similar High/Low (SH/SL).Exaggerated Bullish Divergence occurs, when the price is creating double bottom or similar lows (SL) but indicator is showing Higher Low (HL).
Here is an example chart of Exaggerated Bullish Divergence,
In
the chart above, price created Similar Low (SL) or double bottom but MACD indicator is showing Higher Low (HL) between its crossovers which is Exaggerated Bullish Divergence indicates the flat trend will turn into uptrend soon.Exaggerated Bearish Divergence occurs, when the price is creating double top/Similar High (SH) but indicator is showing Lower High (LH).
Here is an example chart of Exaggerated Bearish Divergence,
In the chart above, we can see that price created double top/Similar High (SH) while MACD indicator created Lower High (LH) between its crossovers which is Exaggerated Bearish Divergence indicating a strong possibility of downtrend.
Now lets make a trading strategy based on divergence.
Trading Strategy
Indicators Used:
Moving Average Convergence Divergence (MACD)
Entry:
1. Identify the divergence
2. After identifying divergence, use MACD crossover to take final entry decision.
Exit:
1. Use MACD reverse crossover to exit.
2. Or, use fixed stop of 20% or 30% or else.
3. Or, use trailing stop.
Stop Loss:
1. Use 6-7% stop loss.
2. Or, exit when reverse crossover occurs in MACD.
