The term divergence has two distinct meanings in common use among technical analysts and forex traders. The first usage refers to the situation that occurs on a chart where a new extreme seen in the price level does not result in a concurrent extreme level in the value of the observed technical indicator.
The second popular usage of the term divergence is often seen in conjunction with its opposite term convergence. This usage refers to how separate or divergent two indicator lines are, and it is often associated with the Moving Average Convergence Divergence or MACD indicator.
This article will deal primarily with the first meaning of divergence. Such divergence comes in two types that are called regular and hidden divergence, and they can each be either bullish or bearish for the exchange rate when seen on charts.
These types of divergence are generally observed by placing a momentum indicator like the Relative Strength Index or RSI in a separate indicator box directly below the price action for a currency pair’s exchange rate on the same overall time scale.
A useful confirmation of waning market strength or momentum that often precedes a directional shift in the market occurs when regular divergence is seen between the price action and a momentum indicator.
Divergence can be especially helpful for traders as a leading indicator when assessing possible future trend reversal situations in markets that are still trending but the strength of the trend is waning.
A lack of divergence tends to confirm an existing trend. Nevertheless, when divergence is seen it can have either bullish or bearish implications for an exchange rate, depending on the nature of the price action.
- Bullish Divergence: usually occurs in a down trend when new lows in the price do not result in a new low in the indicator. This signifies that the prevailing downward trend is weakening and a trader should look for other possible signs of a pending reversal to the upside.
- Bearish Divergence: usually occurs in an up trend when new highs in the price do not result in a new high in the indicator. This signifies that the prevailing upward trend is weakening and a trader should look for other possible signs of a pending reversal to the downside.
A somewhat less commonly used signal than regular divergence is known as hidden divergence. This phenomenon happens when the technical indicator shows a new extreme, but the corresponding price action does not.
While regular divergence often indicates trend reversals, hidden divergence tends to be a continuation indicator that shows when an opportunity to take advantage of a pullback in a trend may exist. This means that a trader can now choose to enter the market in the direction of the trend to profit from its continuation.
Hidden divergence can be either a bullish or bearish signal for the exchange rate for a currency pair, depending on the direction of the underlying trend, but it will usually indicate a coming continuation of the trend.
If the trend is upward, then hidden divergence observed on a momentum indicator is a bullish signal. Conversely, hidden divergence is a bearish signal when the underlying trend is heading downward.
Divergence and Momentum Oscillators
Most of the technical indicators used to observe divergence are momentum oscillators. These indicators that provide a sense as to the strength of a move seen in the market. Some momentum oscillators are used to determine whether a market is overbought or oversold and hence might be subject to a correction.
Popular examples of banded oscillators that measure market momentum include the aforementioned Relative Strength Index (RSI) and the Stochastics Oscillator. The value of each of these indicators ranges between 0 and 100.