Divergence is a commonly used word in science and mathematics. But in the terms of a stock market glossary, the divergence occurs when the price of any asset is moving in the opposite direction to that of an indicator. Traders and investors commonly use these divergences to trade in the stock market. In this article, we will discuss hidden divergence. This is a special type of price to indicator correlation where we get a confirmation about the trend continuance.
What is divergence?
As a general rule, an oscillator should make new highs when the price makes new highs. Similarly, an oscillator should make new lows when a price makes new lows. But sometimes, it doesn’t happen. It doesn’t happen because of divergences. So divergence means a discrepancy between the price and the oscillator.
Divergence is a concept in technical analysis as well as a trading strategy. Divergence trading strategy is an extremely popular trading strategy found in almost all types of markets. Certain oscillators such as MACD, RSI, Stochastics, etc. are used to spot divergence in the market.
Who developed this concept?
The divergence concept is a very old concept and Charles Dow introduced it in his popular Dow Tenets. Dow studied that the Dow Transportation Index tended to make new highs when the Dow Industrials made new highs. He again noticed the same direct proportion when the Industrials made new lows and Transportation followed.
The reason is simple. When industrial production is high, the use of transportation also increases. When industrial production drops, the use of transportation also drops as it happens during times of recession or slowdown.
Dow also noticed the divergence between the two and it was the most important pick. He analyzed that divergence between the two indicated a possible shift in the market. It happened when the Dow Industrials made new highs but the Dow Transportation failed to respond. He thought of a possible discrepancy and it laid the foundation of the divergence concept.
The concept now has developed into a trading strategy that traders, as well as technical analysts, use during trading and technical analysis.
Types of divergences
There are two main types of divergences, regular and hidden divergences.
A regular divergence occurs when either of the two following situations occurs.
- When the prices are making new highs but the oscillators fail to make new highs during an uptrend in the market.
- When the prices are making new lows but the oscillators fail to make new lows during a downtrend in the market.
Regular divergences are of two types.
- Bearish divergence appears during an uptrend. It occurs when prices are making new highs but the oscillators indicate a lower high.
- Bullish divergence appears during a downtrend. It occurs when prices make new lows but the oscillators indicate higher lows.
Hidden divergence is a totally opposite phenomenon of regular divergences. It occurs when the oscillators record new highs or new lows but the price action doesn’t indicate so. Hidden divergences appear during the period of consolidation or correction within the current trend in the market. It indicates that the current trend will remain active as it has the strength to carry on. One might say that hidden divergence is very similar to the trend continuation pattern.
Types of hidden divergence
Hidden divergences can be classified into the following two types as well.
Bullish hidden divergence
A bullish hidden divergence appears during the consolidation period of an uptrend. It occurs when the oscillators indicate higher highs but the prices do not support because the market is in a consolidation or correction phase. Bullish hidden divergence indicates that the uptrend has still the strength. It also alludes that correction is just because of profit-taking and not because of strong selling activities. Therefore, the uptrend in the market is likely to continue.
Bearish hidden divergence
A bearish hidden divergence appears during the reaction or consolidation period of a downtrend. It occurs when the oscillators indicate lower lows but the price action doesn’t indicate so because the market is in a reaction or consolidation phase. The reaction is just because of profit-taking and not because of strong buying activities. That means that strong short selling is still going on and the bearish trend is likely to continue.
How to identify hidden divergence?
There are various indicators that help to identify hidden divergences. Common indicators to identify hidden divergences are:
- Relative Strength Index (RSI): The RSI oscillator is generally used to identify overbought/oversold market conditions during technical analysis. However, there is a way to use the RSI to spot hidden divergence. Make sure to chart the line in a clear and visible way. It will enable you to clearly see the RSI lines and hunt for divergences (regular and hidden).
- Moving Average Convergence Divergence (MACD): MACD is another indicator that can help you to identify this. Traders use it in the same as RSI to spot this form of divergence. You can use two lines on the chart or a histogram to get hidden divergence signals.
- On Balance Volume: On Balance Volume is another volume oscillator that helps to identify hidden divergences. However, it produces fewer signals as compared to other indicators.
- Stochastics Oscillator: Traders also use Stochastics Oscillator to spot hidden divergences. You need to remove its overbought/oversold lines. Leave only the %D line to make it easy for you to spot hidden divergence.
How to trade hidden divergence?
The divergence was just a trading concept but now has developed into a trading strategy. The same applies to hidden divergences. Hidden divergence trading strategies are easy and can be applied to any timeframes. As we have already seen, there can be bullish hidden divergence and bearish hidden divergence. Let us compare the classic and hidden divergence first.
The Bullish and Bearish Hidden Divergences
This is an ideal example of bullish hidden divergence. Bullish hidden divergences occur during the consolidation period. This kind of price consolidation occurs during an uptrend. The price is making higher lows. But the oscillator of your choice is making lower lows. It is an ideal case of entry where you will make a bullish position to expect the uptrend to continue in price. Unless the trend breaks you keep your position and make a profit thereafter. But in the case of classic divergence, a trader makes an entry in the expectation of price reversal.
Similarly, in bearish hidden price divergence, the divergence occurs during a downtrend. The price is making lower highs in the chart, but the oscillator is making higher highs. Here, as a trader, you open a bearish position assuming the price will go down further.
This is the Nifty 50 daily chart. A bearish hidden divergence occurred during June 2019. . It continued till mid-September, 2019. Nifty was making lower highs, MACD was making higher highs in the daily chart. It was a clear signal of hidden divergence. The market was in a downtrend, prices were making lower highs. People who created a bearish position in Nifty had to wait till March 2020 for the big downfall to happen. As it was a daily chart, the effect showed in a broader time scale. After the market went up from September 2019 onwards, the classic divergence showed there was an imminent market downfall looming ahead. Classic divergence warned about price reversal.
A few words about divergences
Divergence trading, be it classic or hidden, needs patience from traders. Also, a trader needs to understand the market scenario before taking a position. The longer the time frame, the longer time it takes to take effect. One should not take a position even if there’s a bullish or bearish divergence signal alone. Look for a supporting signal from other indicators before taking a trade. And at times the divergence trade will test your patience. So hold tight till you get the profit. But if there are other indicators that also show supporting signals, you can take the call. Rest lie on the trader who is actually creating a trading position from a bullish or bearish hidden divergence signal.