Different Types Of Divergences

Two objects diverge when they move in a diverging direction. As one is rising, the other is declining. Divergence trading setups give warning especially when two elements that rise or decline at the same time begin to diverge. That phenomenon alerts one that a change is likely (not definitely) to happen.

One may wonder why are they not in tune this time as they always have been?
There are two types of divergences: bullish and bearish.

Well Known Bullish Divergences

The price is declining but a momentum indicators such MACD, RSI, CCI and the slow stochastic are rising. The momentum is the rate of change of the price-action or its speed. Normally both should be rising in unison, but this time they did not. It could be that the price is latent or a distortion is taking place.

Let me remind one that this article is not about how to trade bullish and bearish divergences but to highlight different types of divergences.

Bullish Divergence

The best known type of divergence is the bullish divergence. It is essentially a bullish warning that occurs when the price-action shows a lower low, but a momentum oscillator denies that by exhibiting a higher low.

Effectively, one has been warned in that instance that the asset may start to rise to align with the momentum oscillation. It is a discrepancy or latency that needed to be confirmed by a direct trading signal given by the price-action.

Therefore, if there is no confirmation, one can not yet place a bullish trade because it just a warning. Though, one should never disregard a bullish divergence warning, it is a mistake to take it as a direct trade signal.

Bearish Divergence

On this occasion it is opposite that is taking place. A momentum oscillator displays a lower high, but the price is still rising or shows a higher high. They are diverging again. In many cases, the price will rise for period before realigning with the momentum indicator. Really, all divergences are just preliminary warnings.

It is similar to saying: "on your marks: ready, steady, go". The divergence is that "on your marks" before the ready.

Divergence In Consolidation

This is a very interesting divergence because the price is oscillating between two key levels, but the momentum indicator is rising. That bullish divergence often occurs when the price slows down during a consolidating after an initial bullish ascent.

The same phenomenon can also occur in a normal consolidation after a trending phase.

A bearish divergence can also take place during a consolidation. Usually, in that instance, a consolidation slows down the price action after an initial bearish move, but the momentum oscillator is declining while the price is still oscillating.

Those two divergences point to a continuation pattern. A continuation is likely to occur after the consolidation if the divergence (warning) is confirmed.
It is always prudent to combine those divergences with a valid breakout trading.

Important Point
I always prefer to use the CCI oscillator for divergences that occur during a consolidation. I will not use another indicator in that case because it works well.

False Divergences (non reliable)

There are two essential false (non reliable) divergences that one must know. They usually take place at the end of the first and in 3rd Elliott waves.

It is better that one ignores divergences that occur during the 3rd wave. They are unreliable. Similarly, divergences that arise at the end of the first wave are also challenging because the initial trend can resume under a strong momentum at the start of the third wave.

In fact, it does not make sense to go against the 3rd wave because it is the most rewarding wave.

Please remember that divergences relating to both first and third waves are very often unreliable. I do not ignore them, but will not trade them either.

Most Reliable Divergence

The most reliable divergences occur at the end of the fifth Elliott wave. However, it does not mean that one should just buy or sell. Trade like a pro. I also prefer to use the RSI indicator during the fifth wave because it does a better job than any other momentum indicator at the end of a trend.

Hidden Divergences

One of the hidden divergences occur when the price exhibit a higher low but a momentum oscillator is still declining.

Another example happens when the price is exhibiting a lower high but the momentum oscillator is rising or shows a higher high. In those instances, the price is leading the momentum oscillators, and many cases they will finally realign with the price-action. One should note that the price-action is the most powerful indicator to itself.

Moreover, a higher low relates to a surge in bullish momentum but a lower high points to a declining momentum.

It does not help to buy or sell a financial asset just because of the different types of divergences. It is really prudent and wise to wait for a definite trading signal by applying a different times frame trading method.

Divergences are just warnings.

Furthermore a divergence does not guarantee that there will be a trading signal.
I like very much hidden divergences because the price is setting a leading signal. On the other hand one should avoid trading the momentum oscillator itself.

Please trade the price-action, but only refer to the technical indicators' warnings to interpret the price-action.
Am I talking too much? I hope not.
Alright you get it.

Distorted Divergences

There are too many distorted divergences in an inefficient financial market. In an inefficient financial market, assets prices are distorted due to many factors such too high volatility, market manipulations, excessively overbought or oversold sectors or an abrupt change of monetary or economic policies.

Those factors can distort both the price action and structures of the momentum indicators. In those instances, MACD, RSI, CCI and the slow stochastic indicators may display a distorted divergence. Quite often, technical traders who never learn to apply the top-down trading method fall into those traps as they buy or sell based on a distorted divergence warning.

With a bit more experience, one can start to spot the distorted divergences.
The number one factor of a distorted divergence is a sharp price move due to high impact economic news or volatility surges.

Other Divergences

Apart from the types of divergences that relate to technical trading there are also fundamental analysis divergences. Those highlight a divergence between an asset's current price and its real fair or true value.

Indeed, value investors are always looking for undervalued assets to profit from the divergence between the current price and the asset's real intrinsic value.

Sometimes, market sentiment negatively impacts the stock price. For example a $24 stock today may be in fact worth $30 based on the fundamentals (financials). Though the current stock price is not yet reflecting its true value, it is just a matter of time (in a normal condition) before it rises to that level (true value).

In those circumstances, one can talk about fundamental bullish divergence.

On the contrary, a $60 stock may be intrinsically overpriced if this is not fundamentally justify. So here we are with $60 stock that may be in fact worth only $30. Obviously, a fundamental bearish divergence is in place due to the divergence between the current market price and the financial asset's true value.

Conclusion

Divergences help to spot discrepancies in the financial markets, and allow one to buy or sell financial assets more profitably. Evidently, it does help to know and understand each divergence type. There are always divergences in the financial markets, so one can not afford to overlook them.

Whether one is a technical trader or investor, one will find all types of divergences useful. Divergences are also useful warnings that no market participant should ignore. I hope this article about different types of divergences will help you buy and sell financial instruments more profitably.

If you really like this article, please share it. Please do not forget to write good words about us in various trading forums. I will really appreciate that. I wish you the very best in your technical divergence trading.

This article is written by G Beaulieu.

Founder Of Stochastic-MACD.com

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