How to profit from bullish and bearish divergence patterns

Trading
November 12, 2019

Thanks to the ease of use, divergence patterns are one of the most popular crypto trading strategies implemented by traders. Divergence is defined as a disagreement between an indicator and the price i.e. a situation in which two different signals are generated. 

In general, we differentiate between two major divergences - bullish and bearish. A bullish divergence occurs when crypto prices create a new low while an oscillator fails to hit a new low. As such, this pattern signals that the bears are losing power, and that the bulls are ready to control the market again. In a high number of cases, a bullish divergence marks the end of a downtrend.

On the other hand, bearish divergence occurs when crypto prices rally to a new high while the oscillator doesn’t hit a new peak. In this situation, this is a signal that the bears are ready to take control again.

In this blog post, we look at the divergence in the context of the MACD, Stochastic and Relative Strength Index (RSI).

Moving average convergence divergence (MACD) divergence

The Moving Average Convergence Divergence (MACD) is an indicator which measures the relationship between the 26-period Exponential Moving Average (EMA) and the 12-period EMA. In the example below, we see that the Bitcoin creates three successive lower highs while the MACD fails to create the third low, but creates a higher peak instead.


MACD bullish divergence (Source: TradingView)
MACD bullish divergence (Source: TradingView)


Although this example generates a buy signal, it actually shows that the usage of only one indicator to enter a trade is not reliable. In this particular case, the price action fails to move higher despite the buy signal generated by MACD. This is called a “false positive divergence” i.e. when the price of an instrument moves sideways - a range or triangle pattern following a trend - and ultimately causes the MACD to pull away from its prior extremes.

Stochastic divergence

A stochastic oscillator is defined as a momentum indicator that compares a closing price of an asset to a set of its prices over a certain period of time. The indicator is used to generate overbought and oversold trading signals, utilising a 0-100 bounded range of values. A reading above 80 generates a buy signal while the reading below 20 issues a bearish signal.


Stochastic bearish divergence (Source: TradingView)


In the example above we see a different situation compared to the MACD bullish divergence. While the price creates a new high, the stochastic decreases in value, thus diverging from the price action. As outlined below, a bearish signal is generated as the bears are ready to take control again. Again, compared to MACD, the price action finally starts to follow stochastic and moves lower in the coming days. This pattern very commonly occurs despite the previous bullish attitude in the price.

RSI divergence

Compared to the previous two indicators, the RSI is arguably the most used momentum indicator out there. It measures the current price strength and compares it to previous prices. Similar to other momentum indicators, the RSI compares the bullish and bearish price momentum as the readings move between two extremes - overbought and oversold. Again, any move outside of the 80 and 20 readings is considered extreme.


Stochastic bearish divergence (Source: TradingView)


In the chart above, we see another example of a bearish divergence as the price action creates a new high, while the indicator, the RSI in this case, moves lower. Subsequently, the price action follows the RSI and creates a large bearish move lower. Besides the fact that the divergence issued a correct signal, always make sure that the signal is cross-checked with other indicators and signals to confirm its reliability. 

Conclusion

  • Trading bearish and bullish divergences is a popular trading style. In general, traders and analysts compare the “disagreement” between an indicator and the price to generate a trading signal. 
  • We make a note of two important divergences - bullish and bearish. 
  • A bullish divergence occurs when the price of a specific instrument creates a new low while an oscillator fails to hit a new low. 
  • A bearish divergence occurs when prices rally to a new high while the oscillator doesn’t hit a new peak. In this situation, this signals that the bears are ready to take control again.

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