Top and Bottom Indicators

In previous chapters, we've explored various candlestick patterns and chart formations like double tops and bottoms, island reversals, head and shoulders, and wedge patterns, each serving as a potential signal for a shift in trend direction. Additionally, we’ve examined the use of momentum oscillators such as RSI, MACD, and Stochastics. 

While these tools are effective on their own, combining price action with momentum indicators often gives traders a sharper edge. When both sets of indicators align, they validate a trend or momentum shift. However, if they contradict each other, we witness what is known as divergence, a key signal that a trend reversal may be imminent. When understood and applied correctly, divergence can be a powerful signal for spotting profitable trading opportunities. 

What Is Divergence? 

In simple terms, divergence occurs when price movement and technical indicators behave in opposite directions. 

Imagine a scenario where price charts indicate a new high, but the RSI or MACD shows a lower high. This mismatch, called divergence, suggests that momentum is not supporting the new price high and a reversal could be around the corner. 

While most technical indicators are lagging by nature, divergence allows them to act as leading signals, giving traders a potential early warning. For better accuracy, divergences should be identified on higher timeframes such as 30-minute, 1-hour, or daily charts. Shorter timeframes may produce frequent but less reliable signals. 

How to Identify Divergence 

Spotting divergence on a chart isn’t always straightforward and requires some practice. However, with a good grasp of trendlines and basic charting skills, it's entirely achievable. 

Here’s how to go about it: 

Step-by-Step Process: 

1. Identify significant swing highs and lows on the price chart. 

2. Draw trendlines connecting these swing points. 

3. Look for corresponding swing highs and lows on momentum indicators (like RSI or MACD). 

4. Draw trendlines on the indicator swing points. 

5. Compare the slopes of the price and indicator trendlines. If they move in opposite directions, you’ve identified a divergence. 

Once you understand how to map trends in both price and momentum indicators, divergences become easier to spot. 

Types of Divergence 

Divergence can be broadly classified into two types: 

1. Regular Divergence – Signals a potential trend reversal 

2. Hidden Divergence – Suggests a possible trend continuation 

1. Bullish Divergence 

Occurs when prices form lower lows but the momentum indicator (like RSI or MACD) forms higher lows. This pattern indicates weakening selling pressure and a potential reversal to the upside. 
 

2. Bearish Divergence 

Happens when prices create higher highs while the indicator forms lower highs. This signals weakening of buying pressure and a possible price decline. 

What Is Hidden Divergence? 

Unlike regular divergence, hidden divergence indicates that the current trend is likely to continue, even after a temporary pullback. 

1. Bullish Hidden Divergence 

This occurs when price forms higher lows during an uptrend, but the indicator creates lower lows. It suggests that the pullback is temporary, and the uptrend is likely to resume. 

2. Bearish Hidden Divergence 

Appears when price forms lower highs during a downtrend, while the indicator makes higher highs. This implies that the retracement is likely to end, and the downtrend will continue. 

Identifying hidden divergences requires attentiveness, but they can be incredibly valuable for anticipating trend continuations. 

Confirming Hidden Divergence 

Hidden divergences are subtle and should always be confirmed before acting on them. Confirmation can be obtained using tools like: 

• Support and Resistance Levels 

• Fibonacci Retracements 

• Candlestick Patterns 

• Volume Analysis 

Waiting for the pullback to complete and using confluence from multiple indicators increases the probability of a successful trade. 

Points to Remember 

• Hidden divergences are harder to detect but signal trend continuation 

• Always confirm divergence before entering a trade 

• Wait for pullbacks to finish before acting 

• Use other tools (Fibonacci, S&R, candlesticks) for confirmation