If you are a forex trader who uses technical analysis, you've likely encountered regular divergence. This occurs when an indicator fails to make new extremes alongside the exchange rate. But have you mastered its powerful counterpart: hidden divergence?
Hidden divergence may be less obvious, but it serves as a critical tool for trend traders. It typically signals the continuation of an existing trend, offering high-probability entry points. By learning to identify and act on hidden divergence, you can significantly improve your trading results.
This guide explains what hidden divergence is, how it differs from regular divergence, and practical strategies for using it in your forex trading.
What Is Divergence?
Divergence in forex trading arises when a momentum oscillator moves in a different direction than the exchange rate, particularly regarding peaks and troughs. This discrepancy can signal potential changes or continuations in market direction.
There are two primary types of divergence:
- Regular Divergence: This acts as a potential reversal signal. It occurs when the price makes a higher high (in an uptrend) or a lower low (in a downtrend), but the oscillator forms a lower high or a higher low, respectively. This suggests the prevailing trend is losing momentum and may be due for a reversal.
- Hidden Divergence: This acts as a potent continuation signal. It appears when the price makes a lower high (in an uptrend) or a higher low (in a downtrend), but the oscillator forms a higher high or a lower low. This indicates that the underlying trend momentum remains strong, and the price is likely to continue in its original direction after a brief pause or pullback.
Understanding these two signals is fundamental for any technical trader looking to identify both market reversals and trend continuations.
Bullish Hidden Divergence
Bullish hidden divergence forms during an overall uptrend. The price chart shows a series of higher lows, indicating that each pullback is shallower than the last—a classic sign of a healthy uptrend. However, the key signal appears on the momentum oscillator, which simultaneously makes a series of lower lows.
This failure of the oscillator to make higher lows, while the price makes higher lows, suggests that the brief selling pressure is weak. It often represents profit-taking by short-term traders rather than sustained selling from major players. This hidden bullish divergence confirms that the underlying buying momentum is still strong and that the uptrend is likely to resume.
Traders often use this signal to add to existing long positions or enter new ones in the direction of the trend.
Bearish Hidden Divergence
Bearish hidden divergence occurs during an overall downtrend. The price chart shows a sequence of lower highs, meaning each rally fails to reach the height of the previous one. Concurrently, the momentum oscillator makes a series of higher highs.
This discrepancy, where the oscillator strengthens while the price weakens, indicates that the buying pressure during these rallies is insufficient. It is likely caused by short-sellers closing their positions for profit, not by new, strong buying interest. This hidden bearish divergence confirms that the underlying downtrend remains powerful and that the price is poised to continue falling.
This signal can be used by traders to add to short positions or enter new ones to capitalize on the continuing downtrend.
How to Spot and Trade Hidden Divergence
Identifying and acting on hidden divergence requires a systematic approach. Follow these steps to integrate this powerful signal into your trading strategy.
1. Determine the Overall Trend
The first and most crucial step is to identify the prevailing trend. Hidden divergence is a continuation pattern, so you must trade it in the direction of the larger trend. A common method is to use a 200-period Exponential Moving Average (EMA).
- If the price is trading above the 200-period EMA, the long-term trend is considered bullish.
- If the price is trading below the 200-period EMA, the long-term trend is considered bearish.
You should only look for long trades (bullish hidden divergence) in a bullish trend and short trades (bearish hidden divergence) in a bearish trend.
2. Select a Momentum Oscillator
Choose an oscillator you are comfortable with. The most popular tools for spotting divergence include:
- MACD (Moving Average Convergence Divergence): Look for divergence between the MACD line/histogram and the price action.
- RSI (Relative Strength Index): Watch for divergence between the RSI line and the price action.
- Stochastic Oscillator: Divergence can be spotted between the %K or %D lines and the price.
3. Scan for Divergence
Once the trend is established, analyze the oscillator for hidden divergence signals:
- In an uptrend, look for the price to make a higher low while the oscillator makes a lower low (Bullish Hidden Divergence).
- In a downtrend, look for the price to make a lower high while the oscillator makes a higher high (Bearish Hidden Divergence).
4. Execute the Trade
After a valid hidden divergence signal is identified:
- For Bullish Hidden Divergence: Consider entering a long trade, perhaps placing a stop-loss order below the recent higher low in the price.
- For Bearish Hidden Divergence: Consider entering a short trade, perhaps placing a stop-loss order above the recent lower high in the price.
5. Manage Risk and Confirm with Price Action
Never rely on divergence alone. Always use it in conjunction with other confirmation signals, such as candlestick patterns or support/resistance breaks. 👉 Explore more strategies for confirming your trade entries and managing risk effectively.
Remember, hidden divergence signals on longer timeframes (like the 4-hour or daily chart) are generally more reliable and carry more weight than those found on shorter timeframes (like the 5 or 15-minute chart).
Frequently Asked Questions
Q: How reliable is hidden divergence as a trading signal?
A: When interpreted correctly within the context of the overall trend, hidden divergence is a highly reliable leading indicator. It excels at identifying periods of consolidation within a trend, signaling the optimal time to position for a trend continuation. Its reliability increases significantly on higher timeframes.
Q: What is the main difference between regular and hidden divergence?
A: The core difference lies in their signals. Regular divergence forecasts a potential trend reversal. Hidden divergence, in contrast, forecasts a trend continuation after a brief pause. Many successful traders use a combination of both to identify reversal points and then confirm the strength of the new trend.
Q: Does hidden divergence work for both bullish and bearish markets?
A: Absolutely. The principle is symmetric. Bullish hidden divergence signals continuation in an uptrend, while bearish hidden divergence signals continuation in a downtrend. The concept applies regardless of the market's direction, making it a versatile tool for all trend-following strategies.
Q: Which indicators are best for spotting hidden divergence?
A: While the RSI, MACD, and Stochastic are among the most popular, the "best" indicator is subjective. It depends on your trading style and preference. The key is to master one or two oscillators and learn how they behave during different market conditions to consistently spot divergence.
Q: Can I use hidden divergence on its own without other confirmation?
A: It is not advisable. While powerful, no single indicator is foolproof. Hidden divergence signals are strongest when confirmed by other technical analysis tools, such as price action patterns (e.g., breakouts from consolidation), key support/resistance levels, or other momentum signals.