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How to Spot Bullish and Bearish Divergence Patterns

Some of the most successful forex traders will tell you that a forex divergence trading strategy is one of the most accurate strategies you can use. This is because the strategy not only makes use of information that is on the charts, but also uses candlesticks that provide clear information about what buyers and sellers are doing in the market. 


This article will present a clear-cut way of identifying bullish and bearish divergence setups on the charts. 


You would be best placed to practice this forex divergence trading strategy on a demo account. A demo account provides a chance for a beginner trader to develop the ability to detect bullish and bearish patterns, as well as detect divergence setups. You can open a FREE demo trading account  in less than five minutes. 

What Is a Divergence?

Divergence simply means to deviate from, or to do something distinctive from what another entity is doing. This definition should provide a clue as to what a divergence setup is. The forex trading divergence strategy employs the use of any suitable oscillator such as the Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD) indicator. Other oscillators such as the DeMarker indicator and the Momentum indicator are equally capable of providing guidance on divergence, so they can be utilized as well. The oscillators used for this strategy are found on the MT4 or MT5 platforms.  


Why are oscillators used? The oscillators are used because they are leading indicators. They tend to point in the direction of the next price move, before this appears on the charts. So they lead the way. Trend indicators follow the market and are lagging indicators, which makes them unsuitable for use in divergence strategies. 

 

So what is divergence? A situation where the price candles’ tops or bottoms point in a different direction from the corresponding tops or bottoms of the indicator’s signal line is called a divergence. Such divergence can be bullish or bearish.

What is Bullish Divergence?

A price chart showcasing bullish divergence is characterized by the formation of progressively lower lows by the price candles when the signal line of the oscillator forms progressively higher lows. It does not matter whether it is a bullish divergence RSI signal or a bullish divergence MACD signal: the principle of spotting and trading the divergence is the same. The sole difference is that a bullish divergence RSI signal uses the price troughs formed by the single signal line to detect the divergence. The bullish divergence MACD signal uses the point of the cross between the MACD lines in the indicator window as the reference signal from the oscillator. 

 

Furthermore, the bullish divergence RSI signal uses a special setup on the RSI signal line known as the failure swing. The bullish divergence setups using the RSI and the MACD indicators are shown below.


Bullish Divergence RSI Setup

 

The bullish divergence RSI setup shows two troughs in the RSI indicator window forming higher lows while the price shows lower lows. The RSI, therefore, leads the price action and is pointing in the new direction. The price follows directly after to correct the divergence in the direction of the indicator’s signal.

What is Bearish Divergence?

A price chart showing bearish divergence is characterized by the formation of progressively higher highs by the price candles in the presence of progressively lower peaks formed by the oscillator’s signal line. This setup can occur in the form of a bearish divergence RSI signal or a bearish divergence MACD signal. The sole difference is that a bearish divergence RSI signal uses the price troughs formed by the single signal line to detect the divergence, while the bearish divergence MACD signal uses the peaks of the MACD lines in the indicator window as the reference signal from the oscillator. The example demonstrated below is that of a bearish divergence MACD signal.


Bearish Divergence MACD Setup
 

We can see that the bearish divergence MACD setup requires the identification of two progressively lower peaks on the MACD indicator line. The occurrence of the divergence setup should alert the trader towards seizing the initiative for necessary trade action. 


Various platforms provide different variations of the MACD indicator. The MACD indicator used above is obtained from the ThinkMarkets MT4 platform. 


The RSI can in addition, be used to spot a bearish pattern of divergence. The snapshot below illustrates how to spot a divergence using the RSI.
 

 Bearish Divergence RSI Setup

 

This setup may look like it delivered very little profit. The fact is that the trade was set up on a daily chart. On the daily chart, a single candle represents a whole day's price action. Some assets have daily trading ranges of up to 200 pips. So initiating a divergence trade on a daily chart provides a realistic chance of banking a lot of pips. Indeed, the move from the possible sell point at 101.17 to the take-profit area totaled nearly 287 pips. This shows the potentials that can be found in a divergence setup. 

The MT5 platform possesses a Depth of Market tool which allows you to spot where the big players are setting up orders. If you employ this tool and see an increase in institutional orders in a direction which follows the divergence trade, this should give you more confidence on how to trade divergence setups. You can get the MT5 and the depth of market tool here.
 

The instances of the divergence trades that you have been shown are overt divergence setups. However, there are divergence setups that are not overt. These are identified as the hidden divergence patterns. Just like the overt divergence setups, hidden divergence setups can be of the bullish or bearish variety. 


Typically, hidden divergences are routinely continuation patterns while the regular divergences signify price reversals. Let's look at in detail what hidden divergences are. 

What is Hidden Bullish Divergence?

A hidden bullish divergence is a setup where the oscillator forms progressively lower lows at the same time that the price is forming higher lows. This setup is frequently seen in situations where the price has been in consolidation or has performed a pullback from an uptrend. This setup, therefore, indicates that price still has some upside momentum and that any pullback is more likely the outcome of profit taking from previous buyers as opposed to strong selling. The emergence of a hidden bullish divergence represents a signal that the prior uptrend is likely to continue. The hidden bullish divergence is presented in this setup below.


Hidden Bullish Divergence Setup


Here, we can see that the RSI formed lower lows at the same time the price formed higher lows. The period of divergence occurred at the time that price was pulling back in a retracement move. Usually divergence is hidden and not immediately obvious until it has occurred. That is why traders need to incorporate other tools or indicators to enable the early spotting of the hidden divergence signal, especially if the trader wants to re-enter the market on the completion of the pullback. Such tools include the Fibonacci retracement tools, which are able to detect the exact pullback levels and match them with the higher lows formed by the price bars/candles.

What is Hidden Bearish Divergence?

The bearish hidden divergence is seen when there is a prior downtrend and an upward retracement of price. Therefore, we see it when there is a price reaction showing lower highs while the RSI or MACD oscillator is higher highs. This setup is an indication that the sellers are merely taking profit and that they still have more momentum left to re-initiate selling when price is more favorable, hence the higher highs that are formed by the price candles. As a rule, downside resumptions of the trend following a pullback are more aggressive than the upside continuation seen in a hidden bullish divergence. Here is what a hidden bearish divergence looks like on the charts.


Hidden Bearish Divergence Setup

 

As we can see on this chart, the price formed lower highs (from the trend commencement to the end of the pullback phase from the downtrend) while the RSI indicator here formed higher highs. As soon as price was done with the pullback, the price resumed in the direction of the prior trend. As we can equally see from this example, the trend continuation move to the south was far more aggressive than the upward continuation seen in the hidden bullish divergence. Therefore, the hidden bearish divergence essentially offers an earning potential that exceeds its bullish counterpart. 

 

On a final note about the hidden divergence setups, you can look at previous resistance areas as a guide to see when the bearish hidden divergence could occur, and also to previous support trendlines to see when a hidden bullish divergence may show up. You should also look towards previous support and resistance areas to determine where to enter and exit any trades based on hidden divergences.

How to determine your entry and exit points

It must be emphasized that divergence signals on their own are not an indication to enter any trades. You still need to obtain the best possible entry and exit points from your setups. This is best achieved by employing tools such as the candlestick patterns, chart patterns, trendlines, as well moving average-based indicators that show crossover signals.


Let us look at the example of the hidden bearish divergence setup and see how to determine a precise entry point as well as an exit point.

Hidden Bearish Divergence Showing Entry Triggers

So here we have taken the previous chart of the hidden bearish divergence to explain how to use other tools to pick out the precise entry spots. In this example, we have used a previous trendline as well as the alligator indicator for this purpose. The trendline expresses a previous support, which was broken to become a new resistance in a move known as the support-resistance flip or S-R flip. This trendline is worthy of consideration as a possible entry point. The pullback move (red arrow) was rejected right at this trendline, and a further confirmation was obtained when the moving averages that make up the alligator indicator crossed at the same level to the downside. This would have provided the trader with a sound basis for a short-trade entry, which would then have turned a profit.


For a bullish divergence setup, refer to the snapshot of the regular bullish divergence in earlier paragraphs. You can see the bullish engulfing candlestick formation which was demarcated with a box. The entry over here would have been to initiate a buy trade after the second bullish candle that engulfs the first one in the setup closes. Such an entry on the regular divergence setup can also be initiated using other reversal candlestick patterns that demonstrate excellent reliability. 


These are the ways in which entries and exits can be executed using the regular divergence trades or the hidden divergence setups.

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