Divergence Cheat Sheet (2024): A Go-To Guide for Traders

Divergence occurs when the price of an asset moves in the opposite direction of a technical indicator, suggesting a potential change in trend. This divergence cheat sheet will break down the different types of divergence, from strong to hidden, and provide you with practical tips and advanced strategies for trading. 

Key Takeaways 

• Divergence in trading occurs when the price of an asset moves in the opposite direction of a technical indicator, suggesting a potential trend change.

• Types of divergence include strong, medium, weak, and hidden, each offering different reliability and trading signals.

• Tools for identifying divergence include RSI, MACD, and Stochastic Oscillator, which help spot divergence patterns and improve trading decisions.

Divergence Cheat Sheet: Types of Divergence 

Divergence occurs when there is a discrepancy between the price movement and a technical indicator. Recognizing these patterns can provide valuable insights into potential reversals or continuations in the market. Let’s explore the different types of divergence in more detail.

Strong Divergence 

Strong divergence is the most reliable type of divergence, often signaling a significant reversal. It occurs when the price makes a new high or low, but the indicator fails to do so, indicating weakening momentum.

Bullish Strong Divergence 

This happens when the price makes lower lows, but the indicator (like the RSI or MACD) makes higher lows. This suggests that the downward momentum is weakening, and an upward reversal is likely. Traders can use this signal to enter long positions as it indicates increasing buying pressure despite the lower price lows.

Imagine the price of a stock is making consecutive lower lows, but the RSI is making higher lows. This divergence suggests that although the price is falling, the momentum behind the sell-off is decreasing, hinting at a possible upward reversal.

Bearish Strong Divergence 

This occurs when the price makes higher highs, but the indicator makes lower highs. This signals that the upward momentum is waning, and a downward reversal could be coming. 

Consider a scenario where the price of an asset is reaching new highs, but the MACD is showing lower highs. This bearish divergence indicates that the buying momentum is fading, potentially leading to a price drop.

Medium Divergence 

Medium divergence is less reliable than strong divergence but can still provide valuable trading signals. It occurs when the price and indicator move in the same direction but with a smaller degree of movement than the price.

Bullish Medium Divergence

The price and indicator both make lower lows, but the indicator's lows are not as pronounced as the price's lows. This suggests a potential reversal but with less certainty than a strong divergence.

If the price of a currency pair is falling and making lower lows while the RSI also makes lower lows but not as deep, this could indicate that the downtrend is losing strength, and a reversal might occur soon.

Bearish Medium Divergence

The price and indicator both make higher highs, but the indicator's highs are less pronounced. This hints at a potential downward reversal, though with less confidence.

When a commodity price rises and makes higher highs, but the MACD makes higher highs at a less steep angle, it suggests that the uptrend could be losing steam, and a price decline might follow.

Weak Divergence

Weak divergence is the least reliable type and often occurs in trending markets. It happens when the price and indicator move in the same direction, but the indicator shows an even smaller movement than the price.

Bullish Weak Divergence

Both the price and indicator make lower lows, but the indicator's lows are much less pronounced. This type of divergence suggests a potential reversal, but it's weaker and should be confirmed with other signals.

Bearish Weak Divergence

Both the price and indicator make higher highs, but the indicator's highs are much less pronounced. This indicates a possible downward reversal but is less reliable and should be used cautiously.

If the price of an index is making higher highs along with the MACD, but the MACD’s highs are barely higher, it suggests that the uptrend may be weakening, but this signal alone is not strong enough to act upon without additional confirmation.

Hidden Divergence  

Hidden divergence is a continuation signal, suggesting that the current trend will likely continue. It's often used to confirm the strength of a trend.

Bullish Hidden Divergence

This occurs when the price makes higher lows, but the indicator makes lower lows. This indicates that the underlying strength of the uptrend is still intact, suggesting further upward movement.

Suppose the price of an asset is in an uptrend, making higher lows while the RSI makes lower lows. This bullish hidden divergence indicates that the uptrend is likely to continue, offering traders a good opportunity to add to their long positions.

Bearish Hidden Divergence 

This occurs when the price makes lower highs, but the indicator makes higher highs. This indicates that the underlying strength of the downtrend is still present, suggesting further downward movement.

Imagine an asset in a downtrend making lower highs while the MACD is making higher highs. This bearish hidden divergence signals that the downtrend is likely to continue, allowing traders to maintain or enter short positions.

Tools for Identifying Divergence  

Identifying divergence requires the use of technical indicators. Here are some of the most popular tools for spotting divergence patterns:

• Relative Strength Index (RSI): The RSI measures the speed and change of price movements. It's a versatile tool for identifying divergence and overbought/oversold conditions. 

• Moving Average Convergence Divergence (MACD): The MACD is a trend-following momentum indicator that shows the relationship between two moving averages. It's excellent for spotting divergence and understanding momentum shifts. 

• Stochastic Oscillator: This indicator compares an asset's closing price to a range of its prices over a certain period. It's useful for identifying divergence and potential reversal points. 

Advanced Divergence Strategies

Once you've mastered the basics of divergence, you can move on to more advanced strategies to enhance your trading.

Multiple Timeframe Analysis

Using multiple timeframes to analyze divergence can provide a more comprehensive view of market conditions. 

For instance, you might spot a strong divergence on a daily chart and confirm it with a shorter timeframe, like the hourly chart. This approach helps you align your trades with the overall market trend and improve entry and exit points.

Divergence in Different Market Conditions

Understanding how divergence behaves in different market conditions is crucial. In trending markets, hidden divergence can be particularly useful for confirming trend strength. In contrast, regular divergence is more effective in identifying reversals in ranging or consolidating markets.

For example, in a strong uptrend, spotting hidden bullish divergence can confirm the continuation of the trend, providing confidence to hold or add to a long position. 

Conversely, in a ranging market, regular divergence can help identify potential breakouts or breakdowns.

Divergence and Volume Analysis

Combining divergence analysis with volume can provide additional confirmation of potential trend changes. 

For example, if you spot a bullish divergence with increasing volume, it strengthens the signal that a reversal is likely. Conversely, a bearish divergence with decreasing volume can confirm a downward trend.

Divergence Cheat Sheet: Tips

Here are some practical tips to help you effectively use divergence in your trading:

• Always confirm divergence signals with other technical indicators or chart patterns to increase reliability.

• Protect your trades with stop-loss orders to manage risk, especially when trading weak or medium divergence.

• Market conditions change, so regularly update your knowledge and adapt your strategies accordingly.

• Divergence signals can sometimes take time to play out. Patience is key to successful divergence trading.

Conclusion

Understanding and applying divergence in trading can significantly enhance your trading strategy. This Ultimate Divergence Cheat Sheet for 2024 has covered the different types of divergence, from strong to hidden, and provided you with the tools and tips to identify and trade these patterns effectively. Join XS today and start applying this divergence cheat sheet!

FAQs

Is Divergence Strategy Profitable?

Yes, a divergence strategy can be profitable when used correctly, especially when combined with other technical analysis tools to confirm signals and manage risk effectively.

What is the Best Timeframe to Spot Divergence?

The best timeframe to spot divergence varies by trading style, but daily and 4-hour charts are commonly used for reliability, while shorter timeframes like 1-hour charts can be used for more frequent opportunities.

What is the Best RSI for Divergence?

The best RSI setting for spotting divergence is typically 14 periods, but some traders prefer adjusting to 9 or 21 periods based on their specific trading strategy and timeframe.