Divergence Trading Strategy: Types of Divergence

Crypto trading has plenty of price action concepts to detect and trade specific price movements. One of them is a trend reversal, which can be anticipated by spotting a divergence between the price and an indicator, employing an effective manner to attend to this kind of directional and profitable move.

A divergence trading strategy can be classified into two primary types of approaches. Recognizing the appropriate one according to market seasons will enhance the trader's performance, potentially leading to better results.

In this article, we will explore those types and how traders can use them to effectively anticipate market sentiment changes.

What Is Divergence In Trading?

Divergence is a charting concept to approach the price movements of crypto assets, seeking an opposite directional move from it in contrast to that forecasted by a technical indicator. It means that if the price of an asset is making higher highs in the price chart but an indicator starts going downward and makes lower highs, a divergence is most likely to emerge.

Divergence is an easy concept to consider when analyzing markets and can provide insight into where price action might go next. It can help traders catch a potential reversal move following a trend, leading to a profitable position trade.

Understanding price and indicator relationships

Discussing the relationship between price and indicators might be more than helpful for a better understanding of the divergence concept.

In this sense, the price of an asset is the quotation at which potential buyers and sellers are willing to place their trade orders. It is affected by demand and supply forces.

On the other hand, an indicator is a technical tool that follows and evaluates the price movements and retrieves a result based on a mathematical formula, suggesting different scenarios for the asset's market season.

For example, let's overview two typical indicators for divergence:

1. RSI: One of the best for divergence detection, it measures the speed change of the price according to average winning and losses calculation, spotting overbought and oversold conditions.
2. MACD: Streamlined for momentum measurement, the Moving Average Convergence Divergence, as its name suggests, can detect worthy divergences through different techniques.

The role of divergence in technical analysis

In the context of technical analysis, the relationship between price and indicators, as exposed previously, plays a substantial role in divergence detection. But it can go beyond.

Divergence can serve as a valuable source of information to forecast potential trend shifts and reversal momentum by comprehending the underlying changes in market sentiment. It can help traders gauge the strength of an asset at specific quotation levels, signaling potential changes before they are reflected in the price.

This way, two events can be analyzed following a divergence:

1. Effective trend reversion.
2. Price level weakness.

Effective Trend Reversion

During trending markets, it is normal for the price to experience some pullbacks. However, those retracements are not strictly a reversion. A typical technique to spot an effective reversion is to draw a trendline and wait for a breakout through it or a moving average.

Price divergence at the end of a trend may anticipate the breakout of that trendline, indicating an effective reversal move.

Price Level Weakness

A price level that has been touched multiple times over a prolonged period tends to weaken. To comprehend this case, imagine the support and resistance levels across a range-bound market whose consolidation phase has formed after a trend.

A divergence that emerges during that consolidation, for example, at the resistance level, will suggest a considerable weakness of the price at that zone, and traders can anticipate a strong rejection move in that case.

Types Of Divergences

The divergence concept as a trading strategy can be versatile and present different types. By understanding the distinct ways divergences might emerge, traders can seek diverse opportunities for continuation or reversal.

Regular-Reversal Divergence

It is a form of divergence for effective reversal signals. This type suits bullish and bearish sides, revealing current weakness at a price level.

For the bullish case:

1. The price would make a lower low.
2. The indicator points to a higher low.

For the bearish case:

1. The price would make a higher high.
2. The indicator points to a lower high.

Hidden-Continuation Divergence

It is a form of divergence for continuation signals, which is usually found during the course of a trend. For example, in a pullback, traders may encounter the following scenarios.

For the bullish case:

1. The price would make a higher low.
2. The indicator points to a lower low.

For the bearish case:

1. The price would make a lower high.
2. The indicator points to a higher high.

Timeframes Divergence

Using different timeframes presents an advanced opportunity window when it comes to divergence. One way to handle this concept is by conceiving longer timeframes as a more reliable source of signals compared to shorter timeframes.

For example, spotting a divergence on an 2h chart could guarantee a more accurate result than on a 15-minute chart. However, if traders go beyond that, they could develop cutting-edge techniques like the following:

Inside Divergence

Picture an 1h candlestick where the price makes a lower low accompanied by a drop in the RSI. However, the price retraces, and on the 5-minute timeframe (where several candlesticks will shape the 1h candle), that retracement forms a regular divergence since this is a shorter timeframe, and the RSI alongside the candlestick formations acts faster.

So, for this case, we have:

1. A lower low and the RSI plunges on the 1h chart.
2. The price pulls back, and on the 5-minute chart, the RSI forms a higher low.
3. An inside divergence appears as a result of the opposite price action along with RSI differences between the 1h and 5-minute timeframes.

Conclusion and Call to Action

Divergence is a simple but powerful and versatile concept that helps traders detect potential reversal moves in the price of a crypto asset, mostly in trending conditions.

It presents two types: regular divergence and hidden divergence. The first case primarily pursues an effective reversal signal, while the second case is a potential continuation opportunity.

In Altrady, traders of all levels can use the RSI indicator and a wide range of charting tools to start backtesting and trading live divergence strategies. Enroll now in a free trial account.