Unlocking Profit Potential: Exploring Hidden Divergences in Trading

Hidden Divergences in Trading

Divergence, a pivotal concept in technical analysis, unfolds in two significant dimensions. If you’ve encountered the MACD indicator, denoting Moving Average Convergence Divergence, you’ve stepped into the realm where divergence takes center stage. In this context, divergence signifies the movement of two lines relative to each other – either diverging by moving apart or converging as they draw closer. The essence of divergence, however, extends beyond the MACD into the intricate dance between price movements and key indicators. Astute traders diligently monitor the divergence between the price and oscillators such as the relative strength index, stochastic, awesome oscillator, or MACD. This phenomenon materializes when the market reaches an extreme high or low, yet the accompanying indicator fails to replicate this intensity. Divergence unfolds in two distinct forms,regular or classic and hidden, and further unfolds as either bearish or bullish. Delving into these classifications is paramount for traders navigating the complex landscape of technical analysis.

Regular Divergence

Regular divergence is a technical analysis concept that plays a crucial role in identifying potential trend reversals in financial markets. Traders and analysts often use regular divergence as a powerful tool to anticipate shifts in market  momentum. Regular divergence manifests when there is a disagreement between the price action of an asset and the corresponding indicators, such as moving averages. This disagreement serves as a warning sign that the current trend may be losing strength, paving the way for a reversal. The rules for regular divergence are distinctive for bullish and bearish scenarios:

• Bullish Regular Divergence: Lower lows in the price chart are accompanied by higher lows in the indicator.  This scenario suggests that, the prevailing downtrend is losing steam, potentially signaling an upcoming shift to an upward trend.
• Bearish Regular Divergence: Higher highs in the price chart coincide with lower highs in the indicator. The price is reaching new highs, but the indicator fails to confirm this strength, signaling potential weakness. This divergence may imply that the current uptrend is losing momentum, foreshadowing a possible reversal to a downtrend. By recognizing and interpreting regular divergence, traders can gain a more nuanced understanding of market behavior.

Hidden Divergence

Hidden divergence, a concept in technical analysis, offers a different perspective from regular divergence. While it provides weaker signals, it is still a valuable tool for traders seeking insights into potential trend continuations. The term “hidden” implies that these divergences are less apparent compared to their regular counterparts, making them a bit more challenging to identify.Rules for Hidden Divergence:

• Bullish Hidden Divergence: Higher lows in the price chart are accompanied by lower lows in the indicator. Despite the price forming higher lows, the indicator suggests that the underlying momentum is weakening. This may indicate that, even though the market is making higher lows, the strength of the trend is decreasing, and a bullish trend continuation is less certain.
• Bearish Hidden Divergence: Lower highs in the price chart coincide with higher highs in the indicator. In this scenario, the price is forming lower highs, but the indicator shows increasing strength. This may imply that the current bearish trend is losing momentum, and a bearish trend continuation becomes less likely.

According to the theory, hidden divergence typically predicts a continuation of the existing trend rather than a reversal.

Hidden Divergence vs. Regular Divergence: Where to Look for It:

The reliability of both types of divergences depends on the timeframe and the strength of the trend. In a strong trend on a medium- or long-term chart, hidden divergence is more likely to signal a trend continuation. On the other hand, regular divergence often occurs before a market reversal and may not necessarily indicate a complete shift in the overall trend. Two common rules to distinguish between divergences are:

• Regular Divergence: Tends to occur before a market reversal. It can be used to trade against the current direction, but additional indicators are often needed to identify potential exit points.
• Hidden Divergence: Typically appears in a strong and established trend, predicting a continuation of that trend. This type of divergence is more likely to be reliable when the trend is solid.

Traders should be cautious and consider other technical indicators, market conditions, and risk management strategies when incorporating hidden divergence into their trading decisions. As with any trading tool, it is essential to use hidden divergence as part of a comprehensive analysis rather than relying solely on this signal.

Regular and Hidden Divergence: Verifying Signals 

Regular and hidden divergences, key concepts in technical analysis, rely on confirming signals through complementary indicators. In instances of regular bearish divergence with the RSI, traders verify a divergence by looking beyond overbought RSI areas. An example includes incorporating the Exponential Moving Average (EMA) cross tool when clear support levels are absent. Shorter-term EMAs, like the 9- and 26-day EMAs, offer precise exit points, enhancing confirmation alongside signals from candlestick patterns like the shooting star. In hidden divergence scenarios, where market strength is affirmed, traders confirm signals using the EMA cross. Shorter-term EMAs, like the 9- and 26-day periods, bring responsiveness to market fluctuations. A crossover where the shorter-term MA surpasses the longer-term MA indicates a trend continuation, supporting a decision to open a long position. However, for timing the rise, considering the opposite EMA cross or placing take-profit targets at resistance levels becomes vital. Incorporating stop-loss levels below the closest support further fortifies risk management strategies. In both regular and hidden divergence contexts, leveraging supplementary indicators and patterns ensures a more comprehensive and informed approach to trading decisions.