Regular Divergence

A regular divergence is used as a possible sign for a trend reversal.

If price is making lower lows (LL), but the oscillator is making higher lows (HL), this is
considered to be regular bullish divergence.
This normally occurs at the end of a down trend. After establishing a second bottom, if the
oscillator fails to make a new low, it is likely that the price will rise, as price and momentum are
normally expected to move in line with each other.

STRONG DIVERGENCE
Below is an image that portrays regular bullish divergence.

Now, if the price is making a higher high (HH), but the oscillator is lower high (LH), then you
have regular bearish divergence.
This type of divergence can be found in an uptrend. After price makes that second high, if the
oscillator makes a lower high, then you can probably expect price to reverse and drop.
In the image below, we see that price reverses after making the second top.

As you can see from the images above, the regular divergence is best used when trying to pick
tops and bottoms. You are looking for an area where price will stop and reverse.
The oscillators signal to us that momentum is starting to shift and even though price has made a
higher high (or lower low), chances are that it won't be sustained.

Hidden Divergence
Divergences not only signal a potential trend reversal; they can also be used as a possible sign for
a trend continuation. Always remember, the trend is your friend, so whenever you can get a signal
that the trend will continue, then good for you!
Hidden bullish divergence happens when price is making a higher low (HL), but the oscillator is
showing a lower low (LL).
This can be seen when the pair is in an uptrend. Once price makes a higher low, look and see if
the oscillator does the same. If it doesn't and makes a lower low, then we've got some hidden
divergence in our hands.

Lastly, we've got hidden bearish divergence. This occurs when price makes a lower high (LH),
but the oscillator is making a higher high (HH). By now you've probably guessed that this occurs
in a downtrend. When you see hidden bearish divergence, chances are that the pair will continue
to shoot lower and continue the downtrend.

Let's recap what you've learned so far about hidden divergence.

If you're a trend follower, then you should dedicate some time to spot some hidden divergence.
If you do happen to spot it, it can help you jump in the trend early.
Sounds good, yes?
Okay, now you know about both regular and hidden divergence.
We hope you got it all down pat. Keep in mind that regular divergences are possible signals for
trend reversals while hidden divergences signal trend continuation.
In the next lesson we'll show you some real-world examples of when divergences existed and
how you could have traded them.

How To Trade Divergences

Now it's time to put those Jedi-divergence mind tricks to work and force the markets to give you
some pips!
Here we'll show you some examples of when there was divergence between price and oscillator
movements.
First up, let's take a look at regular divergence. Below is a daily chart of USD/CHF.

We can see from the falling trend line that USD/CHF has been in a downtrend. However, there
are signs that the downtrend will be coming to an end.
While price has registered lower lows, the stochastic (our indicator of choice) is showing a higher
low.
Something smells fishy here. Is the reversal coming to an end? Is it time to buy this sucker?

If you had answered yes to that last question, then you would have found yourself in the middle
of the Caribbean, soaking up margaritas, as you would have been knee deep in your pip winnings!
It turns out that the divergence between the stochastic and price action was a good signal to buy.
Price broke through the falling trend line and formed a new uptrend. If you had bought near the
bottom, you could have made more than a thousand pips, as the pair continued to shoot even
higher in the following months.
Now can you see why it rocks to get in on the trend early?!
Before we move on, did you notice the tweezer bottoms that formed on the second low?
Keep an eye out for other clues that a reversal is in place. This will give you more confirmation
that a trend is coming to an end, giving you even more reason to believe in the power of
divergences!
Next, let's take a look at an example of some hidden divergence. Once again, let's hop on to the
daily chart of USD/CHF.

Here we see that the pair has been in a downtrend. Notice how price has formed a lower high but
the stochastic is printing higher highs.
According to our notes, this is hidden bearish divergence! Hmmm, what should we do? Time to
get back in the trend?
Well, if you ain't sure, you can sit back and watch on the sidelines first.

If you decided to sit that one out, you might be as bald as Professor Xavier because you pulled
out all your hair.

Why?
Well the trend continued!
Price bounced from the trend line and eventually dropped almost 2000 pips!
Imagine if you had spotted the divergence and seen that as a potential signal for a continuation of
the trend?
Not only would you be sipping those margaritas in the Caribbean, you'd have your own pimpin'
yacht to boot!

Momentum Tricks
While using divergences is a great tool to have in your trading toolbox, there are times when you
might enter too early because you didn't wait for more confirmation. Below are a couple of tricks
that you can make use of so that you have more confirmation that the divergence will work out in
your favor.

Wait for a crossover

This ain't so much a trick as it is a rule. Just wait for a crossover of the momentum indicator. This
would indicate a potential shift in momentum from buying to selling or vice versa. The main
reasoning behind this is that you are waiting for top or bottom and these can't be formed unless a
crossover is made!

In the chart above, the pair showed lower highs while the stochastic already made higher highs.
Now that's a bearish divergence there and it sure is tempting to short right away.
But, you know what they say, patience is a virtue. It'd be better to wait for the stochastic to make
a downward crossover as confirmation that the pair is indeed headed down.

A couple of candles later, the stochastic did make that crossover. Playing that bearish divergence
would've been pip-tastic!
What's the main point here? Just be patient! Don't try to jump the gun because you don't quite
know when momentum will shift! If you aren't patient, you might just get burned as one side
keeps dominating!

Moving out of overbought / oversold

Another trick would be to wait for momentum highs and lows to hit overbought and oversold
conditions, and wait for the indicator to move out of these conditions.
The reason for doing this is similar to that of waiting for a crossover - you really don't have any
idea when momentum will begin to shift.
Let's say you're looking at a chart and you notice that the stochastic has formed a new low while
price hasn't.

You may think that it's time to buy because the indicator is showing oversold conditions and
divergence has formed. However, selling pressure may remain strong and price continues to fall
and make a new low.
You would have been pretty bummed out as trend didn't continue. In fact, a new downtrend is
probably in place as the pair is now forming lower highs. And if you were stubborn, you might
have missed out on this down move too.
If you had waited patiently for more confirmation that the divergence had formed, then you could
have avoided losing and realized that a new trend was developing.

Draw trend lines on the momentum indicators themselves

This might sound a little ridiculous since you would normally draw trend lines only on price
action. But this is a nifty lil' trick that we wanna share with you. After all, it doesn't hurt to have
another weapon in the holster right? You never know when you might use it!
This trick can be particularly useful especially when looking for reversals or breaks from a trend.
When you see that price is respecting a trend line, try drawing a similar trend line on your
indicator.

You may notice that the indicator will also respect the trend line. If you see both price action and
the momentum indicator break their respective trend lines, it could signal a shift in power from
buyers to sellers (or vice versa) and that the trend could be changing. Oh yeah! Break it down like
a Michael Jackson video!

9 Rules for Trading Divergences

Before you head out there and start looking for potential divergences, here are nine cool rules for
trading divergences.
Learn 'em, memorize 'em (or keep coming back here), apply 'em to help you make better trading
decisions. Ignore them and go broke.

1. Make sure your glasses are clean

In order for divergence to exist, price must have either formed one of the following:

Higher high than the previous high

Lower low than the previous low
Double top
Double bottom

Don't even bother looking at an indicator unless ONE of these four price scenarios have occurred.
If not, you ain't trading a divergence, buddy. You're just imagining things. Immediately go see
your optometrist and get some new glasses.

2. Draw lines on successive tops and bottoms

Okay now that you got some action (recent price action that is), look at it. Remember, you'll only
see one of four things: a higher high, a flat high, a lower low, or a flat low.
Now draw a line backward from that high or low to the previous high or low. It HAS to be on
successive major tops/bottom. If you see any little bumps or dips between the two major
highs/lows, do what you do when your significant other shouts at you - ignore it.

3. Do Tha Right Thang - Connect TOPS and BOTTOMS

only
Once you see two swing highs are established, you connect the TOPS. If two lows are made, you
connect the BOTTOMS.
Don't make the mistake of trying to draw a line at the bottom when you see two higher highs. It
sounds dumb but really, peeps regularly get confused.

4. Eyes on the Price

So you've connected either two tops or two bottoms with a trend line. Now look at your preferred
indicator and compare it to price action. Whichever indicator you use, remember you are
comparing its TOPS or BOTTOMS. Some indicators such as MACD or Stochastic have multiple
lines all up on each other like teenagers with raging hormones. Don't worry about what these kids
are doing.

5. Be Fly like Pip Diddy

If you draw a line connecting two highs on price, you MUST draw a line connecting the two
highs on the indicator as well. Ditto for lows also. If you draw a line connecting two lows on
price, you MUST draw a line connecting two lows on the indicator. They have to match!

6. Keep in Line
The highs or lows you identify on the indicator MUST be the ones that line up VERTICALLY
with the price highs or lows. It's just like picking out what to wear to the club - you gotta be fly
and matchin' yo!

7. Ridin' the slopes

Divergence only exists if the SLOPE of the line connecting the indicator tops/bottoms DIFFERS
from the SLOPE of the line connection price tops/bottoms. The slope must either be: Ascending
(rising) Descending (falling) Flat (flat)

8. If the ship has sailed, catch the next one

If you spot divergence but the price has already reversed and moved in one direction for some
time, the divergence should be considered played out. You missed the boat this time. All you can
do now is wait for another swing high/low to form and start your divergence search over.

9. Take a step back

Divergence signals tend to be more accurate on the longer time frames. You get less false signals.
This means fewer trades but if you structure your trade well, then your profit potential can be
huge. Divergences on shorter time frames will occur more frequently but are less reliable.
We advise only look for divergences on 1-hour charts or longer. Other traders use 15-minute
charts or even faster. On those time frames, there's just too much noise for our taste so we just
stay away.

Divergence Cheat Sheet

Let's review!
There are two types of divergences:
1. Regular divergence
2. Hidden divergence
Each type of divergence will contain either a bullish bias or a bearish bias.
Since you've all be studying hard and not been cutting class, we've decided to help y'all out (cause
we're nice like that) by giving you a cheat sheet to help you spot out regular and hidden
divergences quickly.