Using Chart Divergences to Make Trading Decisions

Regular divergence is more common and easier to recognize. When a security's price makes a new high, add chart trendlines on the new high and use them to check against the lower study. If the indicator is not also making a new high, you have a divergence. Sometimes the indicator will be at a lower high; other times the indicator will show a similar high. Either way, if the indicator is not making a new high at the same time price is making a new high, there's a bearish divergence.

If the price is at a new high but the indicator is not, some traders who notice may begin watching for confirmation indicators as potential sell signals. In other words, they may choose to trade in the opposite direction of the trend.

The same analysis can be applied when the price makes a new low. Put the trendlines on the new low and use them to check against the lower study. If the indicator is not also making a new low, you have a divergence. When some traders notice price is at a new low, but the indicator is not, they may begin watching confirmation indicators for a potential buy signal (to trade in the opposite direction from the trend) for this bullish divergence.

Advanced traders who are familiar with options strategies could use divergences as a potential trade trigger to enter something like a short out-of-the-money vertical spread in anticipation of a trend reversal. This risk-defined strategy benefits from time decay while waiting for confirmation of a buy or sell signal. Keep in mind that a regular divergence indicator for a potential buy or sell signal might appear in the near future, but it's not guaranteed to deliver a profitable outcome. 

Another way to trade a regular divergence is to wait for a confirmation buy or sell signal before entering the trade. That signal might appear as a reversal candle pattern, where the price crosses a support or resistance line. Or it might appear as a trade trigger from a confirming chart study. 

Once the price movements show a confirmation buy or sell signal, a directional trade could be entered using a directional options strategy or by buying or selling the underlying security. 

Hidden divergences require a more careful observation of oscillators because most traders focus on price action first. However, there are times when the price and the lower study move in opposite directions—in a way that confirms the current trend. While regular divergence patterns may signal trend reversals, hidden divergences are more likely indicative of trend continuation. 

A bullish hidden divergence occurs when the price of the underlying stock makes a higher low, while the oscillator makes a lower low. This scenario suggests the stock's uptrend is likely to continue despite a brief pullback in momentum. 

A bearish hidden divergence occurs when the stock makes a lower high, while the oscillator reaches a higher high, suggesting the decline is likely to continue despite temporary momentum strength. 

Regular or reversal divergences may be easier to spot, but hidden divergences can precede powerful continued moves in the direction of the trend. 

Just like the alert a yellow flag can give on the racetrack, divergences between lower study chart indicators and price action can be invaluable to traders, potentially giving them a heads up that a trader may want to enter—or exit—a trade in the near future.