Divergence is one of the most powerful concepts in technical analysis, offering traders early warning signals of potential trend reversals. At Green Red Candle LLP, we utilize RSI (Relative Strength Index) and other momentum indicators to identify divergence patterns that can provide high-probability trading opportunities before the market crowd catches on.

What is Divergence?

Divergence occurs when price action and momentum indicators move in opposite directions. This disagreement between price and momentum often signals that the current trend is losing strength and may be about to reverse. It's like a warning bell that rings before a significant market move.

Types of Divergence

1. Bullish Divergence

Bullish divergence occurs when price makes lower lows while the RSI makes higher lows. This suggests that selling pressure is weakening despite the price decline, potentially signaling an upcoming upward reversal.

• Price Action: Lower lows
• RSI Pattern: Higher lows
• Signal: Potential bullish reversal
• Entry Strategy: Look for confirmation above recent swing high

2. Bearish Divergence

Bearish divergence happens when price makes higher highs while the RSI makes lower highs. This indicates that buying momentum is decreasing despite rising prices, often preceding a downward reversal.

• Price Action: Higher highs
• RSI Pattern: Lower highs
• Signal: Potential bearish reversal
• Entry Strategy: Look for confirmation below recent swing low

Best Momentum Indicators for Divergence

1. RSI (Relative Strength Index)

RSI is the most popular indicator for divergence analysis. Set to a 14-period default, it oscillates between 0 and 100. Look for divergence when RSI is in overbought (above 70) or oversold (below 30) territories for stronger signals.

2. MACD (Moving Average Convergence Divergence)

MACD is excellent for spotting divergence through its histogram and signal line. When price and MACD histogram diverge, it often provides earlier signals than traditional oscillators.

3. Stochastic Oscillator

The Stochastic oscillator compares closing prices to price ranges over specific periods. It's particularly effective in ranging markets and provides clear divergence signals in overbought/oversold conditions.

How to Trade Divergence

1. Identify the Trend: Determine if you're in an uptrend or downtrend to know which type of divergence to look for.
2. Spot the Divergence: Look for discrepancies between price highs/lows and indicator highs/lows.
3. Wait for Confirmation: Don't trade on divergence alone. Wait for price action confirmation like a break of structure.
4. Set Entry Points: Enter after confirmation with appropriate stop losses beyond recent swing points.
5. Manage Risk: Use proper position sizing and move stops to breakeven when favorable.

Practical Trading Example

Common Mistakes to Avoid

• Trading divergence alone: Always wait for price action confirmation before entering trades.
• Forcing divergence: Not every price move will have divergence. Be patient and selective.
• Ignoring the bigger picture: Consider overall market structure and trend before taking divergence trades.
• Poor risk management: Use appropriate stop losses and position sizing for each divergence trade.
• Expecting immediate results: Divergence signals can take time to play out. Be patient with your trades.

Key Takeaways

• Divergence provides early warning signals of potential trend changes.
• RSI divergence works best in overbought/oversold conditions.
• Always combine divergence with other technical analysis tools for confirmation.
• Hidden divergence signals trend continuation, while regular divergence signals reversals.
• Practice identifying divergence on historical charts before trading live.