For example, if the price begins to move in a negative correlation to an indicator, (e.g. “higher highs” in price, but “lower highs” in the indicator), this could be viewed as a leading indicator for a potential change in price direction.
Trading volume is one simple example of an indicator that can produce divergences.
In this case, the price will create a divergence when moving in a direction that goes against the trading volume.
For example, if the price is moving up with decreasing volume, there is divergence.
While divergences can occur between an asset’s price and any other piece of data, they are most commonly used with technical indicators, especially with momentum oscillators, such as the Commodity Channel Index (CCI), Relative Strength Index (RSI), Stochastic, and Williams %R.
Types of Divergences
There are TWO types of divergence:
Each type of divergence will contain either a bullish bias or a bearish bias.
If the price is making lower lows (LL), but the oscillator is making higher lows (HL), this is considered to be regular BULLIS divergence.
If the price is making a higher high (HH), but the oscillator is lower high (LH), then you have regular BEARISH divergence.
In an uptrend, if the price makes a higher low (HL), look and see if the oscillator does the same. If it doesn’t and makes a lower low (LL), then you have a hidden BULLISH divergence.
In a downtrend, if the price makes a lower high (LH), look and see if the oscillator does the same. If it doesn’t and makes a higher high (HH), then you have a hidden BEARISH divergence.
Keep in mind that regular divergences are possible signals for trend reversals while hidden divergences signal trend continuation.
- Regular divergences = signal a possible trend reversal.
- Hidden divergences = signal a possible trend continuation.