Divergences and Hidden Divergences

[RichardCox 10]

Divergences and Hidden Divergences

 

Divergences between indicator readings and actual price activity allow traders to identify situations where trending moves are likely to complete. This is valuable information for contrarian traders looking to “buy low, and sell high” as evidence of price divergence is often considered a leading indicator of what is likely to happen next in the market. Divergences occur when indicators fail to confirm higher highs (in an uptrend) or lower lows (in a downtrend). Some of the studies most commonly used to identify price divergences include the MACD, RSI, Slow Stochastic, CCI, etc. Here, we will look at some of the ways changes in momentum present themselves, as well as the differences seen in traditional and “hidden” divergences.

 

Classic Divergences

 

The type of divergence most typically identified is the traditional, or “classic,” divergence, which is an early indication of trend reversals. Bearish divergences occur in uptrends, as indicator readings do not match the higher highs in the market’s valuation. Bullish divergences occur in downtrends, as indicator readings start to rise even though price activity is making lower lows. Classic divergences suggest that a bottom or top might be forming in the market even before the actual price activity has reversed through important support or resistance levels. The first charted example shows the basic structure of a classic divergence. Note the differences between price momentum and the changing direction of the underlying indicator. The second charted example shows the bullish and bearish scenarios in a live chart.

 

Hidden Divergences

 

A twist on the divergence scenario can be seen in the “hidden” divergence, which is actually a continuation pattern and can, in many cases, be more effective in predicting future price movements. Similar to the classic divergence, hidden divergences are seen when prices fail to match the activity in the chart indicator. In a bullish hidden divergence the following requirements must be met. The third charted example shows the structural formation:

 

● Price activity is characterized as an uptrend

● Prices make a higher low

● Indicator reading shows a lower low

 

In a bearish hidden divergence, the opposite characteristics are seen. The fourth charted example shows the structural formation:

 

● Price activity is characterized as a downtrend

● Prices make a lower high

● Indicator reading shows a higher high

 

Hidden divergences are primarily useful for trend traders, as the occurence of this pattern signals that prices have made a corrective retracement in a larger trend -- and that the trend is ready to resume. The main benefit of trading with hidden divergences is that the majority of the market’s momentum is on your side, as you are trading in the same direction as the larger trend. This is a key difference between the hidden divergence and the classic divergence, and one that many new traders miss when looking to implement these strategies. The occurrence of a hidden divergence can also act as a confirmation that the original trend is still valid.

 

Chart Examples with Hidden Divergences

 

The next charted examples show bullish (5) and bearish (6) hidden divergences with a real-time chart. What is important to remember here is that commonly-used indicators (like the MACD, RSI, or Stochastics) should be viewed for more than just an identification of overbought or oversold conditions. There are important relationships that exist between the indicator reading and the price activity itself. Indicator readings are multi-dimensional and can be used in a variety of different trading strategies. With divergences, we are looking for disagreements between specific aspects of the available information and market reactions.

 

Consider the bullish example in graphic 7. Here, the EUR/GBP has broken out of a tightly consolidated range and despite the upside breakout (and higher lows in price) the Stochastic indicator drops into oversold territory and makes a lower low. Since this type of indicator activity is atypical, attention should be paid. Long positions can be taken here, based on a few different arguments: We can see a bullish crossover in the Stochastics, the indicator is starting to move out of oversold territory, and the hidden bullish divergence suggests that the longer term uptrend is still in place.

 

In terms of trade structuring, stop losses and profit targets should be based on the initial reasoning behind the bullish argument -- the validity of the uptrend. This means the trade should be stopped if there is evidence that uptrend has ended. One of the clearest indications that this is occurring would be if prices dropped below the swing low that preceded the upside breakout. For these reasons, stop losses should be placed below this low. When looking at profit targets, the ultimate assumption is that prices will continue making new highs until one of the initial arguments for the trade becomes invalidated. So, in theory, your ultimate profit target should be above the current trend high. It makes sense, however, to book partial profits just below the previous trend high and then move your stop losses to break even once this target is met. This is because there is still reason to believe the previous trend high could still act as resistance.

 

The Rubber Band and Catapult Effects

 

The underlying “power” in the hidden divergence rests on the fact that corrective moves within a larger trend will, at some point, need to catapult themselves back in the appropriate market direction. From a fundamental perspective, this often happens because most of the trend-based profit taking has run its course and the market events that created the trend in the first place still create an accurate representation of the asset’s appropriate market valuation.

 

From a purely technical perspective, these occurrences show that the indicator reading has generated a larger trend pullback than prices themselves. The indicator will need to revert to its mean in order to stabilize. The necessity for mean reversion often creates a significant “snap-back,” and the added momentum that accompanies these moves is usually enough to bring additional higher highs (in an uptrend) or lower lows (in a downtrend). By definition, this means that the earlier trend is resuming and that the continuation pattern has provided an accurate signal. These trend-supportive changes in momentum are sometimes called the “rubber band” effect, or the “catapult” effect, as they are able to send prices into new regions.

 

Conclusion: Indicator Readings are for More than Simple Overbought/Oversold Studies

 

When new traders start constructing positioning ideas with technical analysis, one of the first things we see is the plotting of indicator readings. In most cases, these readings are used to spot places where an asset’s price has become overbought or oversold, and that new positions should be taken in the opposite direction. But when we look at classic and hidden divergences, we can see that indicators can be used in a multitude of different ways. Classic divergences are preferred by contrarian traders, as they suggest a trend is ready to reverse. Hidden divergences offer a different spin on this, and offer trend continuation signals before prices “catapult” themselves in the direction of the underlying price momentum. In both cases, it makes sense to watch your indicator readings in ways that most other traders are missing. Divergences offer one way to get this leg-up on the rest of the market.

[Braam de Villiers 10]

Great Article. Thanks.

[SunTrader 10]

Divergences like trendline breaks, like moving averages, like XYZ etc work, except for when then don't work

 

Knowing the difference, hopefully, is the key.

[Braam de Villiers 10]

Yes. That is a given. Nothing works perfectly. Especially in trading.

[Roger Felton 10]

Now that's a very good basic explanation of Divergences as I've seen. Good stuff, Richard.

 

Divergence is a topic dear to my heart as I recognized it's potential power nearly 20 years ago. When a trend, up or down, reversed into an extended trend in the opposite direction, I could almost always trace the reversal to have "launched" on the trigger bar of a Basic or Extended Divergence signal.

 

But why did so many of the others that occurred prior to the reversal not work? Why did the trend ignore them like they were nerf balls? I studied Divergences for many years searching for the answer. In a nutshell, it comes down to Form and Market Condition. This will filter out about 85% of the divergence duds. The final element is found in filters.

 

Filtering divergences with Volume, Momentum, Market Profile, Elliott Wave, etc. I found to be useless. Hidden Divergence was fairly simple and straightfroward. But counter-trend divergences were a lot trickier and took several years of trial and error study to nail. In the end, I had to create two important filters that also work well with several of my other signals that are not divergence based.

 

One, for instance, monitors several key elements occurring on other bar types and timeframes and instantly places the "crunched" data on the chart I'm trading on so my eyes never have to leave my trading chart and I don't get brain strain trying to keep track of dozens of things are once.

 

So the point I make is that Divergences can be extremely powerful (and profitable) events. When a market takes off, by golly there it is! But, like everything else in trading, it has it's drawbacks and those divergence head fakes can kill ya.

 

Richard clearly showed the What and the Why of Divergence. Master the When and How and you have a powerful weapon in your trading arsenal that will serve you well.:missy:

[Enigmatics 10]

But why did so many of the others that occurred prior to the reversal not work? Why did the trend ignore them like they were nerf balls? I studied Divergences for many years searching for the answer. In a nutshell, it comes down to Form and Market Condition. This will filter out about 85% of the divergence duds. The final element is found in filters.

 

Filtering divergences with Volume, Momentum, Market Profile, Elliott Wave, etc. I found to be useless. Hidden Divergence was fairly simple and straightfroward. But counter-trend divergences were a lot trickier and took several years of trial and error study to nail. In the end, I had to create two important filters that also work well with several of my other signals that are not divergence based.

 

I could not disagree with you more and it sounds to me like you just haven't been able to learn how to incorporate them. I trade divergences full time and no other pattern. I can assure you what helped me sort divergences from one another was the day I started combining volume analysis, VSA, Market Auction Theory, and volume profile.

 

If one does not understand the nature of extremes where supply or demand of volume overcomes the other ...... or one simply runs out, then they will continue to get false signals. If they do not understand where previous volume points of control are, they will not adequately understand the actual mean reversion going on and assess the correct targets (i.e. previous auctions).

Edited October 28, 2013 by Enigmatics

[Roger Felton 10]

One of the things I learned many years ago is, if a trader is very successful trading one way and another trader is successful trading a totally different technique, then what's to disagree on? I stated that trading Divergences using volume to be "useless for me". Every trader must find their own path to a universal destination called Success.

 

I gave volume a good 3 year try. Divergence would work in extremely low volume but not high, Then it would mostly work in high volume and not in low the next day. Volume exhaustion yielded nothing I could use. Volume Profile gave nothing better than a 50/50 win/loss ratio...no better than flipping a quarter. Volume Spread Analysis would say price CANNOT go higher...and it would stay bullish all day long. I could never get any consistent dependable profitable info from anything associated with volume beyond 50/50. So, for me it didn't help. and I studied from the teachings of the top volume "experts" in the industry. So, I took another route and the results were far beyond my expectations.

 

You found your exceptional results using volume to enhance divergence signals and I couldn't be more pleased for you.

If they meet or exceed their goals consistently day after day, which one is wrong? Perhaps Enigmatics can provide the answer that has eluded me for so many years.

Edited October 29, 2013 by tradingwizzard

[Enigmatics 10]

One of the things I learned many years ago is, if a trader is very successful trading one way and another trader is successful trading a totally different technique, then what's to disagree on? I stated that trading Divergences using volume to be "useless for me". Every trader must find their own path to a universal destination called Success.

 

I don't disagree with the idea that not every trader can successfully trade the same way. However, in same cases it's because the trader simply cannot grasp the concept.

 

I gave volume a good 3 year try. Divergence would work in extremely low volume but not high, Then it would mostly work in high volume and not in low the next day. Volume exhaustion yielded nothing I could use. Volume Profile gave nothing better than a 50/50 win/loss ratio...no better than flipping a quarter. Volume Spread Analysis would say price CANNOT go higher...and it would stay bullish all day long. I could never get any consistent dependable profitable info from anything associated with volume beyond 50/50. So, for me it didn't help. and I studied from the teachings of the top volume "experts" in the industry. So, I took another route and the results were far beyond my expectations.

 

.

 

You couldn't get any "consistent dependable profit" because you did not know how to apply them. You speaking to so-called "experts" doesn't change that.

 

If they meet or exceed their goals consistently day after day, which one is wrong? Perhaps Enigmatics can provide the answer that has eluded me for so many years.

 

I'm not arguing against them hitting their goals. I'm arguing your thesis that volume and other related studies cannot be used to identify a more successful divergence trade.

 

It's not typical of people actually sharing their method on this site (everyone loves to speak philosophically), but I'm going to give you an example of a trade I recently posted about on another site where I keep my trading journal ...... This is a 60min shot of JCP ....

 

Pretty simple stuff here. Positive Divergence had been forming as JCP kept making secondary lows on light volume on the daily daily (not pictured here). A 1 month volume point of control formed back at the 8's trapping previous buyers in that auction. A panic flush (sell climax) ensued towards the EOD on 10/21. The mere fact that price then reverted where the panic flush began is a big signal. At that point DEMAND volume in that interval exceeding supply indicated that seller exhaustion has occurred and natural rotation back to major previous "auction" is likely to ensue.

 

 

I've got a countless number of examples of this over in my journal. Heck I even started a thread on this site earlier this year, but have neglected to keep updating it since it garnered little discussion.

 

The thing with this is that a chart is a chart is a chart .... so when you get the confluence of signals that I'm explaining on a higher time interval, the participation is even greater.

Edited October 30, 2013 by tradingwizzard

[Enigmatics 10]

This is a trade I took on ANF last week ..... I detailed in my journal that Demand overcame supply on the Daily chart on 10/11 (Divergence and Reversion Trading - Page 54). Targets were not hard to identify knowing there was demand in the background of the daily chart. At that point I checked back with September's 1 month volume POC ("auction") and saw it was back at 37.00, but there was a congestion zone that needed to be worked through at 36.60 based on the 9/30-10/7 area of the chart on a 60min.

 

Right now it's at 36.90 and is currently 10 ticks away from my 37.00 target. EDIT: Actually the HOD is 37.00 .... target acquired.

 

Daily chart

 

60min chart

 

Previous Congestion Zone from 9/30 to 10/7

Edited October 28, 2013 by Enigmatics

[Enigmatics 10]

Btw, sorry about posting stocks. I just now noticed this was a forex forum, which I hadn't seen when I clicked on the link the email I got from Traders Lab.

[SunTrader 10]

I don't disagree with the idea that .....

 

.....

BTW chart illustrates what Tom Bierovic/Playing for Keeps in Stocks & Futures calls a type II bullish multiple divergence.

[Enigmatics 10]

BTW chart illustrates what Tom Bierovic/Playing for Keeps in Stocks & Futures calls a type II bullish multiple divergence.

 

Interesting. I'll have to check go and read that.

 

Btw, on the JCP trade, I'm only accounting for the current 1 month POC as a preliminary target. September's was up at 8.80-9.00 ..... but still gotta get through 8.00 first since there are previously trapped buyers there looking to breakeven on the trade. Demand volume has eclipsed last Thursday's sell volume by a good margin. This is a good sign for demand returning in the daily interval. Would ideally like it to get up near the 42 million, since that's what it saw when it hit 6.24.

 

This bounce now forming on the daily chart is what Richard Wyckoff would consider the "automatic reversal" .... it's typically from shorts covering some of their position for profit. The eventual bounce high that it forms will then set "the creek" and from there on out it's important to watch to see if there is any more supply that the market operators have to secondary test for.

 

Another thing with divergence setups is that people must come to an understanding that professional buying happens at multiple places. They don't just load up at one price like a day trader ...... hence the secondary lows and whatnot.

Edited October 28, 2013 by Enigmatics

[tradingwizzard 10]

This is a trade I took on ANF last week ..... I detailed in my journal that Demand overcame supply on the Daily chart on 10/11 (Divergence and Reversion Trading - Page 54). Targets were not hard to identify knowing there was demand in the background of the daily chart. At that point I checked back with September's 1 month volume POC ("auction") and saw it was back at 37.00, but there was a congestion zone that needed to be worked through at 36.60 based on the 9/30-10/7 area of the chart on a 60min.

 

Right now it's at 36.90 and is currently 10 ticks away from my 37.00 target. EDIT: Actually the HOD is 37.00 .... target acquired.

 

Daily chart

 

60min chart

 

Previous Congestion Zone from 9/30 to 10/7

 

based on the 60 min chart you're posting there, I would say it's a SELL from an Elliott point of view (I trade mostly Elliott)........zigzag, abc, b wave a contracting triangle, c wave a clear impulse........at least 61.8% out of the whole move that started and the previous lows should come........let's see, keep this updated

TW

[Enigmatics 10]

based on the 60 min chart you're posting there, I would say it's a SELL from an Elliott point of view (I trade mostly Elliott)........zigzag, abc, b wave a contracting triangle, c wave a clear impulse........at least 61.8% out of the whole move that started and the previous lows should come........let's see, keep this updated

TW

 

What somebody wants to do from here on out is their prerogative.

 

I already detailed the trade I was looking for, which was to 37.00, showing a previous poster how to combine elements such as volume, VSA, Volume Profile, and Market Auction with Divergence trading.

[handle 10]

Have you found any success in divergences between markets? Such as between gold and silver?

[Enigmatics 10]

Have you found any success in divergences between markets? Such as between gold and silver?

 

Certainly. I used to trade the S&P via the SPY all the time this way, particularly on an intraday level. Check out these couple of sequences on the GLD.

 

A "positive divergence" recently played out. On 9/18 there was a SOS (sign of strength) candle on high demand, which eclipsed any previous signs of supply. This put the ball squarely in the bull's court. However, the market operators don't always make it so easy. If they sense any latent supply or want to shake out weaker longs, they will conduct a secondary test of supply. That supply showed itself at the volume-by-price level I marked as an HVN (High Volume Node). Large VBP bars (HVN's or POC's) represent previous auctions where there are trapped buyers looking to break even on their trade.

 

GLD went on to make a lower low on 10/11 at 121.85. Notice that as price made that lower low, the MACD made a higher low. This is confirming that even though price wasn't behaving bullishly, there was actually buying within the selling. This is a concept that most traders have a tough time conceptualizing since they're mostly fixated on breakout trading resistance levels, where in fact they are buying into liquidity that the public is providing to the pro's to sell into.

 

Remember, DEMAND was in the background based on 9/18's activity. Once the sellers give up and/or the market operators are done shaking out weak longs, it does not take much effort to move price back in the direction of the original demand. That's when the reversion begins. The gap above the trend line was the biggest signal that market operators were bullish again.

 

 

From a broader context though, GLD is simply rotating around the 6 month and 1 Year volume POC (Point of Control). It'll take much larger demand to move price away from such a significant auction level.

 

EDIT: Actually here is the 1 year chart

 

Edited October 29, 2013 by Enigmatics

[Enigmatics 10]

This is an interesting sequence because not only does it show you a legitimate positive divergence setup, it also shows you a false one. on 4/15, GLD experiences a big selling climax. This means supply is in the background. It sees a slight bounce, but on light demand. It runs into resistance and essentially double topping at the 143 level.

 

Market operators then go and conduct a secondary test of supply. The stock forms a double bottom around the 130 level and a positive divergence forms, but what is missing here to clue us in on whether or not bulls have come back into the picture at this level? The volume. Demand does not even attempt to exceed supply at these levels. This gives sellers more reason to hold their positions and others to join the party. In the process it locked in buyers, who in the future will look to break even on their trade.

 

The bear wedge is broken to the downside, but notice that the MACD still isn't making lower lows. This is a clue to start trying to identify buying opportunities and seller exhaustion. It finally shows up on 6/28. Just look at the demand volume. It finally overcame previous supply. A reversion then takes place all the way back to the 6 month POC.

 

 

As you can see here in this next chart, it found initial resistance back at that previous double bottom 130 level, which I told you would likely have sellers ... including stubborn shorts who are defending their position (or adding) as well as previous buyers looking to break even. The selling is light though because there's demand in the background now and would go on to make another bounce high (shown in my previous post on the 1 year chart).

 

Edited October 29, 2013 by Enigmatics

[Enigmatics 10]

The main idea behind all of this goes as follows:

 

Volume POC's are "auctions" where the most buyers/sellers of that time frame agreed on price. Once one side takes over the auction, there is only so far it can move price. Two things can then happen.

 

1. It can consolidate and form a POC around the new level for support

 

or

 

2. It can hit an extreme which Market Auction Theory calls a VAL(Value Area Low) or VAH(Value Area High). At this "extreme" we look for when the dominant side has exhausted itself or the other side took back control. Then we let the natural mean reversion to previously marked volume POC's happen.

 

In my humble opinion, most traders get caught attempting breakout trades at these "auctions" I speak of. They have no idea it's going on because they do not use volume profile and are essentially trading within major "congestion".

 

Trade the "extremes" not the "middle".

Edited October 29, 2013 by Enigmatics

[Enigmatics 10]

Interesting. I'll have to check go and read that.

 

Btw, on the JCP trade, I'm only accounting for the current 1 month POC as a preliminary target. September's was up at 8.80-9.00 ..... but still gotta get through 8.00 first since there are previously trapped buyers there looking to breakeven on the trade. Demand volume has eclipsed last Thursday's sell volume by a good margin. This is a good sign for demand returning in the daily interval. Would ideally like it to get up near the 42 million, since that's what it saw when it hit 6.24.

 

This bounce now forming on the daily chart is what Richard Wyckoff would consider the "automatic reversal" .... it's typically from shorts covering some of their position for profit. The eventual bounce high that it forms will then set "the creek" and from there on out it's important to watch to see if there is any more supply that the market operators have to secondary test for.

 

Another thing with divergence setups is that people must come to an understanding that professional buying happens at multiple places. They don't just load up at one price like a day trader ...... hence the secondary lows and whatnot.

 

I don't disagree with the idea that not every trader can successfully trade the same way. However, in same cases it's because the trader simply cannot grasp the concept.

 

 

 

You couldn't get any "consistent dependable profit" because you did not know how to apply them. You speaking to so-called "experts" doesn't change that.

 

 

 

I'm not arguing against them hitting their goals. I'm arguing your thesis that volume and other related studies cannot be used to identify a more successful divergence trade.

 

It's not typical of people actually sharing their method on this site (everyone loves to speak philosophically), but I'm going to give you an example of a trade I recently posted about on another site where I keep my trading journal ...... This is a 60min shot of JCP ....

 

Pretty simple stuff here. Positive Divergence had been forming as JCP kept making secondary lows on light volume on the daily daily (not pictured here). A 1 month volume point of control formed back at the 8's trapping previous buyers in that auction. A panic flush (sell climax) ensued towards the EOD on 10/21. The mere fact that price then reverted where the panic flush began is a big signal. At that point DEMAND volume in that interval exceeding supply indicated that seller exhaustion has occurred and natural rotation back to major previous "auction" is likely to ensue.

 

 

I've got a countless number of examples of this over in my journal. Heck I even started a thread on this site earlier this year, but have neglected to keep updating it since it garnered little discussion.

 

The thing with this is that a chart is a chart is a chart .... so when you get the confluence of signals that I'm explaining on a higher time interval, the participation is even greater.

 

JCP on fire right now .... hit 8.12

[SunTrader 10]

JC Penney: Getting Better?

 

JC Penney: Getting Better? - Stocks To Watch - Barrons.com

[Enigmatics 10]

JC Penney: Getting Better?

 

JC Penney: Getting Better? - Stocks To Watch - Barrons.com

 

What's funny is, do you know how many times I've seen reports like that come out after I've correctly identified a long term positive divergence on a daily or weekly chart?

[tradingwizzard 10]

What's funny is, do you know how many times I've seen reports like that come out after I've correctly identified a long term positive divergence on a daily or weekly chart?

 

there is a saying that price can stay in a divergence mode more than a trader can stay solvent

 

TW

[Enigmatics 10]

there is a saying that price can stay in a divergence mode more than a trader can stay solvent

 

TW

 

Ya, if that trader is simply watching candles and the squiggly MACD line. That's where there rest of the analysis comes in via volume histogram, volume profile, Market Auction Theory, Volume Spread Analysis.

 

It reminds me of people over at the Stockfetcher forums. I use that service to conduct my scans and I'm constantly seeing people looking for the magic filter, avoiding the inevitability that they will have to monitor/manage/analyze that trade as it's in progress. They want the RSI or any other magic indicator to hit a certain number in order to tell them when to buy and for it to hit a certain number in order to know to sell.

 

The whole "oversold/overbought" issue with indicators is a trap if someone doesn't understand when a stock is being marked up as opposed to "ranging".

Edited November 11, 2013 by Enigmatics

[tradingwizzard 10]

Ya, if that trader is simply watching candles and the squiggly MACD line. That's where there rest of the analysis comes in via volume histogram volume profile, Market Auction Theory, Volume Spread Analysis.

 

It reminds me of people over at the Stockfetcher forums. I use that service to conduct my scans and I'm constantly seeing people looking for the magic filter, avoiding the inevitability that they will have to monitor/manage/analyze that trade as it's in progress. They want the RSI or any other magic indicator to hit a certain number in order to tell them when to buy and for it to hit a certain number in order to know to sell.

 

The whole "oversold/overbought" issue with indicators is a trap if someone doesn't not understand when a stock is being marked up as opposed to "ranging".

 

tell that to the guy with the "billionaire indicator"

 

:crap:

 

TW

[SunTrader 10]

there is a saying that price can stay in a divergence mode more than a trader can stay solvent

 

TW

The expression made famous by John Maynard Keynes

 

“The market can stay irrational longer than you can stay solvent.”

 

had nothing to do with divergence(s).