Divergence Pattern explained: Understanding the basics
Cryptocurrencies have grown to become one of the most popular assets to trade in recent years, due the opportunities they present. However, these opportunities are only rewarding because they come with great risks. As is often the case — great risk brings great reward. This risk comes from high volatility associated with cryptocurrencies. However, by using technical analysis tools and indicators, traders can determine the most likely direction the price might take.
For example, a crypto price chart is a tool that can reveal important price patterns, like divergence patterns. This is an important pattern, and it’s very useful for traders to know how to recognize them. This guide will explain what a divergence pattern is and what it can tell you.
What is the divergence pattern?
In finance — including crypto trading — there is a technical pattern known as a divergence. This is something that occurs when the asset’s market price moves in the opposite direction of another piece of data. This is usually represented by technical analysis indicators. It’s one of the chart patterns traders and investors use to determine market strength. When the market begins to show. Signs of weakness, it can lead to a consolidation period or even a full trend reversal.
One of the most commonly used indicators that show divergence is trading volume. It’s a simple indicator but can reveal a divergence when it moves in the opposite direction of the price. For example, if the price is growing but the volume is dropping, this is a sign of divergence. However, volume is only one example, and there are other pieces of data. Some commonly used pieces of data are the Relative Strength Index (RSI) and the Stochastic RSI.
You can easily spot divergences on the chart when specific chart patterns form. Note that divergences can be both positive and negative. A positive divergence happens when the asset’s price is dropping, but other indicators show strength in the asset. A negative divergence occurs in the opposite case — when the price rises, yet the oscillator suggests weakness in the asset.
While traders need to be very cautious and aware of divergences, they can be helpful in crypto trading. They can help traders determine entry and exit points, decide on stop-losses and predict price action.
What can the divergence pattern tell you?
Divergences in technical analysis typically signals major positive or negative price moves. It can be used to predict bullish and bearish trends, or decide entry and exit points, as mentioned. Essentially, technical analysis helps indicate when a price is on the verge of experiencing a move.
Investors can plot oscillators, such as the Relative Strength Index (RSI) and Moving Averages (MA), to help predict such price movements. Let’s say that you choose to use the RSI and compare its performance with that of the price. If the price rises and reaches new heights, the RSI should ideally do the same. However, if it makes lower highs, this signals a weakness in the trend.
This is when the trader needs to decide what to do and how to proceed. They could simply exit a position and collect their profits while they are ahead. If they believe that the price will go against the oscillators a little longer, they can use stop-loss to help limit any potential losses.
What types of divergence patterns are there?
There are several types of divergence patterns that you should be aware of. The two main ones are a regular divergence and a hidden divergence. We can then categorize them by whether they are bearish or bullish.
This leaves us with four different patterns:
- Bullish regular divergence
- Bearish regular divergence
- Bullish hidden divergence
- Bearish hidden divergence
In addition to these, there is another one, known as an exhaustion divergence. Now, let’s break down each of them and see what they mean and look like.
Bullish regular divergence
To start off, we have regular divergences, which is also known as a classic divergence. In a case where the regular divergence is bullish, we call it a bullish regular divergence. This refers to a situation when a price drops to new lows while the indicator signals potential growth.
Let’s say that you’re monitoring the price of Bitcoin (BTC) and its RSI. If the price of Bitcoin is dropping while the RSI suggest a rise, this is a bullish divergence. In this instance, theory suggests that the price should eventually catch up and start performing the same as the momentum oscillators.
Until then, however, traders have a chance to invest and prepare for the upcoming growth. Obviously, in order to do so, they first need to recognize the divergence pattern.
Bearish regular divergence
Another form of regular divergence that you can expect to see is bearish regular divergences. This is pretty much just the opposite from what was described above. In this scenario, the price is likely to head up, while the indicators show weaknesses. This indicates that the price is going to lose its momentum in the near future.
Bullish hidden divergence
Next, we have hidden divergences, which can also be bullish or bearish. Hidden divergence are created when the price reaches a higher high/low, and the indicators forms lower highs/lows.
Bullish hidden divergences tend to occur after a correction takes place. Typically, the value of an asset makes a higher low, while the oscillators form a lower low.
Bearish hidden divergence
On the opposite side, we have bearish hidden divergences. This is what happens during price recoveries and surges. You can spot bearish hidden divergences by identifying periods where an asset’s value forms a lower high. However, the oscillators, clearly creates a higher high.
Traders can use this as a signal that suggests a trend reversal is on the horizon. In this case, they should either sell off their coins, or at least use stop-loss to minimize potential losses.
Exhaustion divergence
The last type of divergence that we must discuss is the so-called exhaustion divergence. This is a pattern that occurs when the price of an asset reaches an extreme level. Its momentum starts to weaken, indicating that the trend is losing strength.
This is one of the strongest and most powerful types of divergences, and it shows that a trend reversal is imminent. Apart from that, it could also mean that the asset is about to enter a period of consolidation. In any case, it’s best for traders to know how to spot it and prepare adequately.
The divergence pattern’s advantages and limitations
Like all other technical indicators, divergence patterns have their advantages and disadvantages:
Divergence pattern pros
- Historically, they have proven to be very reliable indicators.
- Offers a lot of trading opportunities for short-term traders.
- Indicates bullish and bearish trends before they arrive.
- It can help you identify support and resistance levels.
Divergence pattern cons
- Divergence can be difficult to recognize even for experienced traders.
- It’s not a strong indicator and is best used as a confirmation indicator.
- It’s not ideal for beginner traders
Should you rely on the divergence pattern?
From everything we have discussed, it’s fair to assume divergence patterns can be very useful whilst trading. It can help you recognize the arrival of bullish and bearish trends reliably. The problem is that it’s not very easy to recognize divergences in a timely manner. They can be quite subtle at times, so hunting for divergences can be tough.
Instead, we suggest you use other indicators alongside divergences in order to spot trend reversals. Once you suspect that a trend reversal might be coming, use divergence pattern to confirm it. That way, you will know what to look for and it will be much easier to confirm your suspicions.
FAQs
What is a divergence pattern?
A divergence pattern is a technical indicator that suggests a trend reversal. Bullish and bearish trends can be spotted before they start affecting the price. Divergence patterns can help you see them ahead of time, although they are often very subtle.
Are divergences bullish or bearish?
Divergences can be both bullish and bearish. It depends on which market it appears in, and what it signals.
What are the types of divergences?
The types of divergence are different patterns that suggest different upcoming price behavior. There are three main ones. However, their number can be increased if we separate them by whether they are bullish or bearish.
What are the three types of divergences?
The three main types of divergence include Regular Divergence, commonly referred to as classic divergences, hidden divergence, and exhaustion divergence. You can also split them into bullish or bearish divergence types, depending on the type of market they appear in.
