Cryptocurrency traders employ different strategies to cherry-pick signals and ensure profitability. Out of the many, trading divergences is popular and one of the most powerful trading concepts.
How so? Well, they can be used to mark out the beginning, the end of a long rally, and tops for shorting.
The good news is that this isn’t rocket science. It is pretty easy to spot divergences.
Whenever they occur, you can quickly compare them to different divergences that we shall lay out later in this article.
For this, we highly recommend you bookmark this article for your future reference.
Over time, it has been demonstrated that divergences can offer high-quality trading signals, especially when used together with other tools and concepts.
Divergences may lag—since momentum indicators also lag.
Regardless, it is possible to pick out reliable and helpful entries or exit positions when used correctly, especially for swing trend traders.
The Link Between Price Momentum and Divergence
Before diving in and explaining what divergences are, we should understand that prices of any asset only trend 30 percent of the time. They often consolidate, whipsaw, and wipe clean accounts of traders who don’t employ proper risk-management strategies.
Experienced traders, regardless of how irresistible a setup may appear, always deploy a risk management plan. That means stop loss, trailing stops, and take profits, adjustable depending on the existing margin.
Behind every price upswing or downswing is participation that defines momentum. This helps define the direction—the trend—and the volatility levels.
Typically, momentum is measured by the size of price swings measured from a pivot. The steeper the slope of the swing—down or up—the stronger the underlying momentum.
The activity of traders defines trends which in turn can help plot out divergences.
The more rapid the trend is, the higher the momentum and vice versa—as aforementioned.
A skill that traders must develop over time is when to pick out price momentum and how to tweak a strategy accordingly in light of the evolving state of the market.
What is a Divergence?
This is where divergence comes into play.
To simplify, divergences are used to determine whether the existing trend is fizzling out, causing reversals or hinting at the possibility of trend continuation.
Divergence forms on the primary chart and momentum indicators like the MACD, Stochastic, or RSI, can help identify such patterns.
Trading volumes can also be used in tandem with price action to pick out divergences.
Often, a trader will use divergences to:
- Determine price momentum
- Likelihood of a price trend reversal
- So, What Happens in a Divergence?
When the price action of, say BTC or ETH, moves in opposite directions with a momentum technical indicator, then divergence is forming.
In layman terms, a divergence will form whenever the technical indicator “clashes” or “doesn’t disagree” with price action.
For example, the price of BTC/USD could be moving lower, but RSI is increasing, reversing from oversold territory.
On the flip side, BTC/USD could be inching higher, but the RSI is decreasing, moving from overbought territory.
There is an active divergence pattern that may be exploited by trend or reversal traders in both cases.
Keen traders would immediately adjust their plan in light of this development, either exiting or doubling down.
Now that we have a solid foundation of what a divergence is in its basic form, let’s explore some of the common divergence patterns:
A Regular Bull Divergence Pattern
This occurs when prices are making lower lows but the technical indicator prints higher lows.
There is a bull divergence in play when this happens, and bears are actively losing power to push prices lower, paving the way for bulls to take over and push prices higher.
Whenever a bull divergence pattern forms, it often signals the end of the downtrend.
If you are using an RSI indicator, for example, a bullish divergence will form if a buy signal prints in the oversold territory while prices continue to move lower.
A Regular Bear Divergence Pattern
This pattern forms when prices are edging higher while the momentum indicator prints lower highs.
This “disagreement” suggests bulls are losing grip, waning, possibly marking the end of the uptrend.
A bear divergence pattern points at intense profit taking—or selling, superseding buying pressure.
For swing traders reliant on trending markets, they can exit their longs.
Meanwhile, reversal traders can prepare for “shorts” in anticipation of a pullback, correcting the over-valuation of the digital asset.
If you use RSI as your primary indicator, a bearish divergence pattern will form if prices increase while momentum is decreasing, turning from the overbought territory.
A Hidden Bullish Divergence Pattern
You will spot hidden bullish divergence during the correction of an uptrend.
How? Well, the indicator would make higher lows while prices won’t—instead flat-lining in a consolidation phase.
What this means is that the uptrend is still valid. The dip in price action is momentarily and profit-taking.
Soon, bulls will flow back, pushing prices even higher. This is the so-called “buy the dip” divergence.
A Hidden Bearish Divergence Pattern
If prices are in a downtrend and the price prints lower high and the technical indicator prints higher high, a hidden bearish divergence pattern has formed.
Traders can interpret this as a profit-taking pullback that won’t last long since bears are still in control. This is the so-called “sell the rally” divergence.
Which Time-Frames Are the Best For Trading Divergences?
Traders are usually spoilt for choice when picking out signals.
The more aggressive day traders often lean on short time frames where signals are plenty. Meanwhile, swing and long-term traders prefer medium to higher time frames from the 4HR to weekly charts.
But here is the cool thing about divergences: They print in all time frames.
Expect to find divergences even in the 1 minute or the monthly chart.
The baseline, nonetheless, is this: The lower the time frame, the more the divergence but the weaker the reversal or trend continuation.
This means, divergences in higher time frames, say the 4HR chart, carry more weight than a divergence that forms in the 15 minutes chart, for example.
What’s more, higher time frame divergences are few. Once printed, though, their significance is profound, influencing strategies.
What Are the Best Indicators for Divergences?
Aforementioned, a divergence prints on the primary chart when prices don’t agree with the primary indicator, often in the secondary chart.
A big part of divergence is momentum. This is because momentum has a direct impact on price volatility which readily shows in the price chart.
Therefore, a trader would ask: Which is the best indicator to use for picking out divergences?
The immediate answer is Momentum indicators.
In their basic form, a momentum indicator is used to measure the rate of change of the price of a crypto asset. They are perfect in revealing the exact point in time when the market price of an asset is changing.
By using a momentum indicator, a technical analyst will readily determine the strength or weakness of the underlying token or coin.
And there are many types: From the Commodity Channel Index (CCI), Moving Average Convergence Divergence (MACD), Stochastic, RSI, and more, traders are spoilt for choice.
Among them all, the Relative Strength Indicator (RSI) is emerging as a standard and typically referred to whenever a divergence of any type forms.
Trading divergences is powerful but we shall discourage you from using this tool in isolation to determine buy and sell signals.
Even if a regular divergence forms—especially in lower time frames—it won’t guarantee that the trend will reverse any time soon.
Accordingly, using divergences as a standalone leading indicator is not recommended.
Instead, traders can use divergences to gauge the strength of trends, only providing the probability of subsequent price action but not for clear-cut entry and exit positions.
A trader can, once a divergence pattern prints —in conjunction with other indicators–refine their entries and deploy a suitable risk management plan.
Adding secondary criteria and confirmation tools as part of your trading arsenal prevents a trader from taking trades that “won’t go anywhere,” subsequently improving the quality of signals.