BTC: Bullish and Bearish Divergence Cheat Sheet - Trading 101

Almost all forms of technical analysis involve the use of lagging indicators, as they are a great way to find the overall direction of the price action in either the immediate or medium term ahead. There are very few indicators that use any type of leading analysis due to the nature of the market psychology. That is because we don’t know what will happen - we can't predict the future, but we can most definitely try and find a way to understand how the market behaves and make a certain judgment off of this theory. All we can do is interpret what kind of future behavior may occur based on past events – this is the basis of all psychology and significant portions of medicine: we can only predict future behavior by analyzing past behavior. Now, just because most of the tools and theories used in technical analysis are lagging in nature – it doesn’t mean that there is no method of leading analysis.

Divergences are one method of turning lagging analysis into leading analysis – it’s not always 100% accurate because of market situations on a daily basis, but divergences can detect anomalies and differences in normal price behavior based on supply and demand of prices. Divergences are useful in identifying when a significant trend may be ending or when a pullback may continue in the prior trend direction. Let’s review some of those now.

Divergences are easily one of the most complex components to learn in technical analysis - that's if you are patient and have a good disciplined setup. First, they are challenging to identify when you are starting because we always try to find bias within our trade setup. Second, it can be confusing trying to remember which divergence is which and if you compare highs or lows. It is essential to know those divergences themselves are not sufficient to decide whether or not to take a trade – they help confirm trades, and if you have other indicators that are implying a buy or sell signal, these divergences can increase your trade setup by three folds.

When we look for divergences, we are looking for discrepancies between the directions of highs and lows in price against another indicator/oscillator. The RSI is the oscillator used for this lesson. We are going to review two of the main types of divergences:

Bullish Divergence - A bullish divergence occurs, generally, at the end of a downtrend. In all forms of bullish divergences, we compare swing lows in price and the oscillator. For a bullish divergence to happen, we should observe price making new lower lows and the oscillator making new higher lows. When bullish divergence occurs, prices will usually rally or consolidate.

Bearish Divergence - A bearish divergence is the inverse of a bullish divergence . A bearish divergence occurs near the end of an uptrend and gives a warning that the trend may change. In all forms of bearish divergence, we compare swing highs in price and the oscillator. For a bearish divergence to happen, we should observe price making new higher highs and the oscillator making new lower highs.