Trading 101: What are Divergences? The Best Tool to Confirm Market Reversals

2021/09/16 10:24:24

With the introduction of price charts and several analyzing techniques, it is certain that prices in the financial markets do not move in a random direction. Technical analysis enables traders to read, understand, and predict future prices. And the crypto markets are no different. Despite the fundamentals being completely different from that of traditional financial markets, the technical side of things remains the same – as prices move based on demand and supply of the underlying asset.

Price Action and indicator-based analysis are the two most popular ways to perform technical analysis. Though price action and indicators follow completely opposite approaches, there are techniques that try to blend both to solidify and make the strategy firmer.

One such famous strategy that combines price action analysis and an indicator is divergence. The compelling divergence strategy helps traders give an edge to their price action analysis by adding an indicator to the chart. The indicator itself is not essentially interpreted in the analysis but plays a major role in the identification of divergence in the market.

Introduction to Divergence

Markets majorly move either in an uptrend or a downtrend. An uptrend is a sequence of higher highs and higher lows, while a downtrend is a sequence of lower lows and lower highs. Most indicators are designed to follow the price. For instance, if the market is making higher highs, the indicator also follows the same higher high trajectory.

As indicators purely follow the price, they always need to be in sync with each other. But there are scenarios in the market when the indicator goes off sync with the price action. For example, if a market is in an uptrend, the indicator appears to be in a downtrend. Such a situation in the market is referred to as divergence.

Interpreting Divergence

Firstly, many traders assume that divergence itself is an indicator that depicts the occurrence of divergence in the market. But, in reality, divergence is simply a market scenario that needs to be manually identified by traders by analyzing the price action in conjunction with an indicator. Usually, divergence is identified by oscillator indicators such as MACD, RSI, Stochastic, etc.

Divergence is an indication that the price is doing something unusual than expected. For instance, a higher high on the price charts but no higher high on the indicator signifies that the market is attempting to change direction.

Essentially, divergence occurs due to the sudden change in the momentum of the market. If the price is showing signs of slowing down, and if the momentum suddenly picks up, the indicator fails to react to the sudden movement. As a result, the absence of reaction from the indicator on the price action causes divergence to occur in the market.

In the chart shown below, we can see that the price action is heading north, making higher highs and higher lows. But, at the same time, if we look at the MACD indicator, the highs are getting lower every step of the way. Hence, the given market is under divergence as the indicator is out of sync with the price action.

Occurrence of Divergence in the Bitcoin Price Chart | Source: BTC/USDT

How to trade Divergence?

Divergence is one of the most commonly used techniques to trade market reversals. A market simply does not transit from an uptrend to a downtrend or vice versa. The transition must happen either as a consolidation or slowing down of the predominant direction.

Based on the above idea, divergence can be applied to time a potential reversal in the market. But the reversal signal must be initially identified using price action techniques before heading to apply the indicator and spot divergence.

One of the simplest ways to apply divergence into price action analysis is using the concept of Supply and Demand.

To brush up a real quick, Supply is a level in the market where the prices tend to fall due to the lack of interest to buy the asset, while demand is a level where the price tends to rise significantly due to high interest to buy the asset.

The end goal of the strategy is to anticipate a market reversal. According to the working of the strategy, we need to first mark out the major demand/supply levels based on the higher timeframe. And if the market shows divergence around these levels, we can prepare to go long at a demand zone or short at the supply zone.

In the market depicted below, the demand zone stands between $1,700 and $1,800. After reacting off from the demand zone for the first time, the price began to move south. In other words, the downtrend began from $2,400 and continued south, making lower lows and lower highs. But as the price action clearly had lower lows sequences, the indicator, for the same corresponding time frame, had higher low sequences – confirming that the downtrend has come to an end and the demand zone is set to take off. Hence, traders can go long after a slightly major reaction from the demand zone.

Divergence Explanation on the Bitcoin Price Chart | Source: BTC/USDT

To sum up, divergence is a market scenario that occurs quite commonly in the crypto market and greatly helps to confirm a potential reversal in the market. As far as the interpretation is concerned, divergence is an indication that price is moving abnormally, perhaps to trap the retail trades and get them wrong-footed.

So based on price action analysis in conjunction with an oscillator (to identify divergence), traders can easily speculate on highly rewarding reversal setups. Stay tuned and watch the KuCoin Blog for more interesting and valuable educational content. All the best!

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