This article attempts to describe and clarify how to recognize and use both Bullish Divergence and Bearish Divergence. It is aimed at people who are
new to technical analysis and those who wish to re-visit some basics. It includes some useful tips for people wishing to trade / rather than just analyze.   

Divergence is a by-product of the use of price charts and indicator(s). It is not always present to herald a change of trend / but when it does appear it is well worth heeding the early warning of possible price reversal. There appears to be a hierarchy of usefulness of indicators regarding divergence. Some are extremely powerful while others rarely (if ever) provide this added benefit.

What is Divergence?

Divergence is the word used to describe the condition where the price and an indicator give opposite views.  It is when the interpretation of price action suggests continuation of the current direction at the same time as the interpretation of an indicator [or other confirmation tool] suggests a reversal.  

When divergence is identified, it is the indicator that assumes “naming rights”. Consequently, if the price suggests a continued upward movement and the indicator suggests downward movement, the bearish (i.e. downward) nature of the indicator takes control – hence Bearish Divergence. Alternatively, if the price action suggests continuation of a downward movement and the indicator suggests upward (i.e. bullish) movement, this is a case of Bullish Divergence. 

The convention for determining bearish divergence is to look at the peaks of both price and indicator. If the price peaks are getting higher and the indicator peaks are getting lower (bearish) then you have bearish divergence.

For bullish divergence it is a little different. Here it is the troughs of both price and indicator that are important. When the price troughs are getting lower and the indicator troughs are getting higher (bullish), the price action and the indicator are displaying bullish divergence.

Although it is seldom (if ever) mentioned in the text books and / or reputable published articles, accurate record keeping and communication of findings should nominate the indicator displaying divergence with price. For example “bullish divergence is being shown between XYZ and the slow stochastic indicator”. 

Bullish Divergence

[Fig.1: Weekly chart of the BHP Billiton (BHP) showing Bullish Divergence with the 20 period Commodity Channel Index.]

Figure 1 shows BHP on a weekly price chart from April 2008 to November 2008. From its highest point in May

2008 to its lowest point in November 2008, BHP lost 60%of its value in 27 weeks. This was a fairly significant drop

Points A and B (Fig.1) indicate price troughs on BHP.  

Below the bar chart of price action is a chart of the 2period Commodity Channel Index (CCI). It shows trough in the indicator values at points C and D.  A and B on the price chart correspond to C and D respectively on the indicator chart.  

This is an example of bullish divergence.  

One interpretation of this divergence phenomenon is that the mathematics of the indicator suggests that the downward thrust of the price action maybe unsustainable. This was in fact the first significant technical sign that the decline in BHP price action may have bottomed.

TRADERS BEWARE !

Although bullish divergence can be a very powerful signal that the downward move may be losing strength it has proved to be unsatisfactory as the primary signal to enter a trade. It is not uncommon to find a three touch divergence.  

Bullish divergence has, however, shown itself to be very effective signal to close out short trades.  

Bearish Divergence

[Fig.2: Weekly chart of the BHP Billiton (BHP) showing Bearish Divergence with the 20 period Commodity Channel Index.]

The price action illustrated in figure 2 shows BHP rising in price from $23.90 in January 2007 to $47.70 in October 2007. That is a 98.58% rise in 40 weeks. This is quite a significant rise / especially for a blue chip stock. 

As shown (Fig.2) there were significant price peaks at points E and F on the price chart.

Points G and H are corresponding peaks in indicator (CCI) values. 

Whereas the line joining E and F is rising, the line joining G and H is falling. 

This is bearish divergence and the mathematics suggests that the upward movement cannot be sustained. This particular instance of bearish divergence was at the beginning of a 35% drop in BHP share price. 

ATTENTION TRADERS AND INVESTORS

The presence of bearish divergence may be a signal to pay particular attention to stop management procedures and / or a call to commence hedging strategies to protect built-up profits. Bearish divergence is not necessarily a signal to short the market.

Indicators Displaying Worthwhile Divergences

In Animal Farm, George Orwell introduced the concept that “all animals are equal, but some are more equal than others.” This may also be applied to indicators showing divergence. Nearly all indicators may display divergence at some time / but there are some that show it more consistently and with greater degrees of accuracy and usability.

While there are no formal statistics to back this up, anecdotal evidence and practice suggest that the following four indicators have proved to be valuable in their handling of divergence studies. They are, in order of accuracy, consistency and usability:

1. Commodity Channel Index (CCI)

2. Slow Stochastic Indicator

3. Relative Strength Index

4. Moving Average Oscillator 

The first two appear to get their strength from the fact that they include high, low and close prices in their calculation. The second two are close-only calculations. Note also that the moving average oscillator is the same as an MACD-Crossover with the trigger set at “1”. 

For people starting out on the road to divergence studies, these four may provide a good beginning.

Time Frames for Divergence Studies

Divergence studies and signals are completely independent of time frames in use. That is, they operate and display effectively on monthly, weekly, daily or intraday charts.

Develop the skill of identifying divergences on one time frame and then apply it across the full range of chart time frames.

Trading Implications

Bullish and bearish divergences can provide an early warning of a significant change in trend. This is an important consideration for traders in terms of trade entries and trade exits. Before using this (or any other) tool in the live trading environment, it is essential that traders develop and test their proposed strategy and apply strict risk management and money management rules to all trades.

The real value for profitable traders is the price action. The indicator (including divergence studies) may provide early warning so that better and more profitable trade exits might be made.

Summary and Conclusion 

• Bearish divergence is taken from the peaks.
• Bullish divergence is taken from the troughs.
• Divergences may provide early warning of trend change.
• Divergences are not always present / but pay attention when they are there. 
  
• Remember to test divergence trading strategies before going live with them.