Divergence Trading Strategy: Identifying Divergence

In the realm of crypto trading, divergence occupies a relevant place as one of the most straightforward but distinguished strategies whose implementation requires proper identification along different market seasons.

Trends, ranges, support and resistance, alongside chart patterns, are concepts discussed throughout this article, and how they correlate regarding divergence, helping traders spot the best trading opportunities.

Exploring Divergence Concept

Divergence is a technical concept tool employed to spot and take advantage of the opposite relationship between the price movement of an asset and an indicator, especially those based on oscillators like MACD, RSI, and Stochastic.

Traders can find divergence in the market when a crypto asset price goes toward an opposite path from that indicated by an oscillator, for instance, making a lower low while the indicator makes a higher low. This circumstance might anticipate a potential reversal movement but also offers insight into the market sentiment, possible trend continuations or shifts, and price weakening levels.

Divergence in crypto markets

In the context of crypto markets, attending divergences can be a real challenge if traders do not consider the volatile nature of this market, the rapid price changes, and sudden sharp movements.

Typically, when we discuss the innate forces affecting the price of a cryptocurrency, the overleveraging that induces significant liquidations by the positions of most inexperienced retail traders is one of the main topics pointed out.

However, in the actual crypto environment, increasingly adopted by institutions, traditional trading concepts like market makers and manipulation also play a role in identifying successful divergences. It is crucial to consider this to avoid possible false signals.

Characteristics of divergence

When identifying divergences, it is crucial to consider the characteristics of those most likely to be successful. Generally, two consequent price swings shape the conditions for a divergence, which leads to take note into the following:

• For the bullish case, the price action should make a lower low, while an oscillator indicates a higher low. Also, the indicator may plunge to a lower low while the price climbs to a higher low. It will depend on the type of divergence.
• For the bearish case, a higher high in the price while an oscillator indicates a lower high should appear. Again, depending on the divergence type, the indicator may point to a higher high while the price declines to a lower high.

Likewise, it is necessary to be aware that not all divergences will be effective and not to confuse with other concepts like equal lows/highs or chart patterns like double top/bottom.

Types of divergences

As mentioned, the bullish and bearish cases for a divergence can present two variant types each. So, which are those types? Let's overview them:

1. Regular Divergence: This type typically suggests a reversal momentum after a trend. It might be preceded by a weakness at a certain price level.
2. Hidden Divergence: This divergence seeks the continuation of a price movement. The entry opportunity for that continuation can be spotted in a pullback during a trend.

Identifying Divergence

Up to this point, identifying divergences will require the analysis of different market conditions, like ranges and trends or their role at key levels of support and resistance. Significant chart patterns like the head and shoulders also influence the accurate spotting of potential effective divergence. Let's discuss all of them.

Divergence in Trending Markets

Trending markets tend to have oscillators like RSI cruising over the overbought/oversold levels for a prolonged period. When the trend weakens by reaching a key area, it is likely to appear as a divergence following a price action swing high or low, for example, the last higher high or lower low according to the direction of the trend, resulting as effortlessly identified opportunity when the oscillator differs from those ultimate swings.

Commonly, at the end of the trend, chart patterns like a double top/bottom would appear, suggesting a potential reversal. The appropriate identification would rely on the indicator behavior:

• MACD: The MACD and signal lines, for example, could decline progressively along the overall trend until a trendline breakout with a plunge of the indicator reveals a powerful reversal momentum.

Divergence in Ranging Markets

Generally, range-bound markets are consolidation phases formed after a large price movement or a prolonged trend. While the price moves sideways between key levels of supply and demand, these levels also tend to weaken as the price reaches them, implying a possible breakout.

Two situations can arise concerning price divergence in range markets:

1. Divergence can precede the breakout opportunity or emerge after a false breakout.
2. Divergence can signal the range continuation when the price is rejected from a resistance level (supply) or bounces from support (demand).

Divergence at Support And Resistance Levels

A divergence emerging over a proven support or resistance level would lead to the following scenarios:

• Confirmation: Key levels add a layer of strength to the thesis of price reversal.
• Breakouts: Trendline breakouts, for instance, can be anticipated by spotting a divergence in supply and demand levels.
• False Breakouts: In ranges, typical false breakouts can be detected by a divergence.

Divergence and Chart Patterns

Spotting chart patterns can be a powerful method to take advantage of the divergence concept. For example:

1. After a breakout through the neck of the Head And Shoulders pattern, a return of the price to that area that will act consequently as a support or resistance is expected.
2. Then, a divergence can emerge on that return to the neck.
3. This divergence can even be formed into a double top/bottom pattern.

Example of Successful Divergence Application

4h chart, Swing Trading divergence with multiple confluences

1h chart, if we zoom in on the previous chart, we find this example of using a different time frame, RSI and chart pattern confluence. The New York session opening.

Conclusion and Call to Action

Divergence is a powerful concept for detecting weaknesses at specific price levels in the cryptocurrency market. Those weaknesses could then lead to effective price reversals and trend shifts.

Accurately identifying divergences requires evaluating conditions like trending and ranging markets alongside associated concepts like support and resistance or chart patterns, which can serve as valuable tools for confirmations and dispersing false signals.

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