Divergence in trading occurs when a discrepancy arises between an asset’s price movement and its momentum indicators. Two of the most commonly used indicators for spotting these discrepancies are the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD). Recognizing divergence can help traders anticipate potential trend reversals or continuations.
Before diving into more advanced concepts like hidden divergence, it is essential to grasp the fundamentals of conventional divergence. Both types of divergence require an established trend to be meaningful—whether upward or downward.
What Is Divergence?
Divergence signals a disagreement between price action and momentum. In a typical scenario, price and momentum move in sync. When they start moving in opposite directions, it suggests underlying weakness or strength in the trend.
For example, during an uptrend, prices often make higher highs. If the momentum indicator, such as RSI, fails to make a corresponding higher high and instead forms a lower high, a bearish divergence occurs. This indicates that buying momentum may be waning, even though prices are still rising.
Bearish Divergence
Bearish divergence forms in an uptrend when the price makes a higher high, but the momentum indicator makes a lower high. This signals that the upward momentum may be weakening. It does not guarantee an immediate price drop but suggests caution—a potential trend pause or reversal may be near.
Consider a line chart of SPY during an uptrend in early 2025. The price reached a higher peak, as expected in an uptrend. However, the RSI did not confirm this movement and instead made a lower peak. This subtle shift indicates slowing momentum. While the price did eventually turn downward in this instance, it is important to note that bearish divergence does not always lead to a decline. Sometimes, the price may simply enter a consolidation phase.
Bullish Divergence
Bullish divergence occurs in a downtrend when the price makes a lower low, but the momentum indicator forms a higher low. This suggests that selling pressure is fading, and a trend reversal to the upside may be imminent.
Understanding Hidden Divergence
Hidden divergence often serves as a continuation signal rather than a reversal signal. It appears within the context of an ongoing trend and suggests that the trend is likely to persist.
Bullish Hidden Divergence
In an uptrend, bullish hidden divergence occurs when the price forms a higher low, but the momentum indicator forms a lower low. This implies that despite temporary momentum weakness, the underlying trend remains strong, and prices are likely to continue rising.
For instance, review a chart of GLD (gold ETF) from late 2024. The first three valleys in both price and RSI moved higher, confirming the uptrend. However, the fourth price valley was higher than the previous one, while the corresponding RSI valley was lower. This hidden divergence suggested that the uptrend would continue—which it did.
This type of divergence is called "bullish" because it implies upward price movement. Some traders also refer to it as "positive" divergence.
Why Hidden Divergence Matters
Hidden divergence may seem counterintuitive. If momentum is weakening, why would the price continue rising? The key is to recognize that other market forces—such as strong buyer interest—can outweigh temporary momentum dips. For example, if RSI valleys remain above 50 (a bullish zone), it indicates underlying strength even if momentum appears weaker.
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Using MACD for Divergence Trading
While RSI is popular, MACD is another effective momentum indicator for identifying divergence. It works across various timeframes and asset classes.
On a weekly chart of Costco (COST) during an uptrend, a series of higher price valleys coincided with lower MACD valleys. This bullish hidden divergence signaled trend continuation—prices continued to climb.
This demonstrates that the concept of divergence is not limited to a single indicator. Whether using RSI, MACD, or others, the principles remain consistent.
Dealing with Conflicting Signals
It is common to see both bearish divergence and bullish hidden divergence on the same chart. This can be confusing: one signals a potential reversal, while the other suggests trend continuation.
Many traders consider hidden divergence more reliable because it aligns with the prevailing trend. Trend-following signals often carry more weight than counter-trend signals. However, nothing in trading is absolute. Divergence signals should be used in conjunction with other analysis tools rather than in isolation.
Practical Tips for Trading Divergence
- Confirm with Trend: Always identify the trend first. Divergence signals are most reliable when they align with or confirm the broader trend.
- Use Multiple Timeframes: Analyze longer timeframes for trend direction and shorter timeframes for entry timing.
- Combine with Other Indicators: Use divergence alongside support/resistance levels, volume analysis, or candlestick patterns for higher-probability trades.
- Avoid Overtrading: Not every divergence leads to a meaningful price move. Be selective and focus on high-quality setups.
Frequently Asked Questions
What is the difference between divergence and hidden divergence?
Divergence typically signals a potential trend reversal, while hidden divergence suggests trend continuation. Divergence occurs when price and momentum move in opposite directions at potential reversal points, whereas hidden divergence appears during trend pauses within an ongoing trend.
Can divergence be used alone for trading decisions?
No. Divergence should be used as part of a broader trading strategy. Combining it with other technical tools—such as trendlines, moving averages, or volume indicators—improves reliability and reduces false signals.
Which is better for divergence trading: RSI or MACD?
Both are effective. RSI is often used for overbought/oversold conditions, while MACD captures trend momentum. Some traders prefer using both to confirm signals.
How reliable is hidden divergence?
Hidden divergence is generally considered a strong continuation signal, especially when it aligns with the overall trend. However, like all technical tools, it is not foolproof and should be validated with other analysis methods.
What timeframe is best for divergence trading?
Divergence can be identified on any timeframe, but longer timeframes (like 4-hour or daily charts) tend to produce more reliable signals than shorter ones.
Can divergence occur in sideways markets?
Divergence is most effective in trending markets. In sideways or choppy markets, divergence signals may be less reliable due to the lack of a clear trend.
Conclusion
Divergence and hidden divergence are powerful tools for identifying potential trend reversals and continuations. While bearish and bullish divergences can warn of trend weakness, hidden divergences often confirm trend strength. These concepts apply across various indicators, including RSI and MACD, and multiple timeframes.
Remember that no single indicator should dictate your trading decisions. Always use divergence in combination with other technical analysis methods and risk management strategies. In part two of this series, we will explore how these concepts apply in downtrending markets and delve into more advanced techniques.