What is divergence?
Divergence is best summed up as any indicator failing to make a new high or low when the price does. I've annotated the below charts to show what divergence looks like. Let me say flat out that diverging indicators in isolation mean nothing and most traders shouldn't fade (trade against) the trend without confirmation of the trend breaking down. What divergence CAN give you is a warning sign that the new price level may not be accepted or that momentum is slowing down. Also, divergence is not limited to one indicator. I use divergence techniques on RSI, Macd, volume and many other indicators.
On the first chart, the first case of bearish divergence was successful and as the trend broke down the lower strength gave way to selling pressure. The second instance had no success and the price continued on higher. This is why you wait for the trend to break to confirm the divergence before entering a trade. Only if your an aggressive trader would you take a divergence trade without confirmation, the payout could be higher but so is the risk your taking.
Another thing I want to mention is often times in the market the number 3 comes up, generally speaking. I would say if you have divergence on 3 new highs/lows the probability of that move breaking the trend is exponentially higher than a move with 2 diverging highs/lows. Not a guarantee, but being that trading is an odds game this could be the tilt of odds that makes you profitable. And again wait for that confirmation of the trend breaking down.
Below is an example of
bearish divergence with 2 higher highs on the price, yet the RSI had 2 lower highs. Wait for the trend to break and take your signal to enter short.
Below is an example of
bullish divergence with 3 lower lows on the price, yet the RSI had 3 higher lows. Wait for the trend to break and take your signal to enter long.
