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By Vito Henjoto, Technical Analyst, GFT

Divergence is a fantastic tool to use if you can spot it – but for some people, they miss out and just can’t see the wood for the trees.

Considering that the trading world is mostly sentiment driven, price itself does not filter out emotions, sentiments and bias of market participants. Because of this, price often fails to warn traders of any impending changes in the trend.

Divergence is simply the discrepancies between price and a technical indicator – where technical indicators, which are often an average of price, do not conform to price movement. These warning signs are in the form of changes in the underlying momentum of the given financial instrument.

Most commonly used technical indicators to detect divergence is the Oscillator types, such as:

–    MACD
–    Stochastics
–    Relative Strength Index
–    CCI

These oscillators are the easiest to detect Divergence because of their purpose as a momentum indicator.

The big questions for traders are: ‘Is the market going to continue to go higher/lower?’ or ‘Is the drop/rise over? Is this the bottom/top?’

Identifying Divergence in the market actually answers the questions above.

There are two categories of divergence; there’s regular divergence, which normally heralds a reversal in the market, and hidden divergence, which provides confirmation for a trend continuation.

Since the purpose of a divergence is to identify changes in a trend, they will not work when the market condition is sideways.

Here we’ll discuss Regular Divergences in detail, looking at different criteria and effects of the various classes filed under Regular Divergence.

Regular Divergence:

These divergences are probably the easier to identify amongst the two categories. In theory, the diagram below shows how to identify a regular divergence.

 

The strength of a regular divergence is classified into three different types:

–    Class A, which is the poster boy of regular divergence and the strongest type of divergence.
–    Class B, Medium strength divergence, less accurate.
–    Class C, The weakest form of Divergence and generally ignored.

Tracking reversal possibility in a trend using divergence requires an in-depth understanding on how these Classes of regular divergence are formed.

CLASS A DIVERGENCE:

Class A divergence normally occurs before a retracement or a reversal occurs in the market.

A bullish divergence occurs when price continues to push lower but Oscillators are starting to stgelop a higher low. This indicates that momentum for price to push to the downside is waning, and price movement to the downside is likely to be sentiment based and will not last long.

A bearish Class A is exactly in reverse, where price continues to push higher but momentum shown by Oscillators are not matching price movement. Because the discrepancy is extreme, this type of divergence signals a quick and sharp turn in the market.

CLASS B DIVERGENCE:

Class B divergence is fairly uncommon, as one of the main indication for a Class B is the existence of A double bottom or a double top chart formation. Contrary to popular belief amongst traders, a double top and double bottom does not have a high probability as a reversal signal. So it is best to use separate analysis to compliment a Class B divergence.

Double Tops and Double Bottoms are often a sign that the market is entering an equilibrium phase and a trend will likely transition into a range-bound market. Because of this, Class B is weaker than a Class A divergence and are often associated with a gradual turn in the market.

Class C Divergence:

Class C divergence is so obscure that few traders come across it. Traders that do come across the Class C Divergence do not understand what category is the divergence because of its rarity; this is often ignored.

It is the weakest type of divergence; market reversals can be very short lived and choppy. A Class C divergence occurs in a smaller time frame and under a choppy market condition. It’s good to know in case you come across it, but it’s generally discounted.

A few tips to make Identifying Divergence easier are:

1.    Understand and identify the underlying trend.
2.    When the market is in an uptrend, identify changes in the swing highs (TOPS) for any signs of bearishness
3.    When the market is in a downtrend, identify changes in the swing lows (Bottoms).
4.    Regular Divergences are Reversal Signals, so there’s no point looking for a bullish divergence in an uptrend, and vice versa.
5.    Divergence is just a warning sign, not a confirmation!
6.    Regular Divergences work best when the market is Oversold or Overbought.

As always, if you have any questions for me, simply ask me via the Ask the Expert panel here.

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