Bullish and Bearish Divergence Trading Signals

Bullish Divergence vs Bearish Divergence

Typically, you would look for clues between the indicator and price action in order to make a decision. One of the most powerful trading signals that combine price action analysis with the use of indicators is the Divergence signal, and that’s what we intend to discuss in this article.

Bullish Divergence vs Bearish Divergence

Bullish divergences are, in essence, the opposite of bearish signals. Despite their ease of use and general informational power, trading oscillators tend to be somewhat misunderstood in the forex trading industry, even considering their close relationship with momentum. At its most fundamental level, momentum is actually a means of assessing the relative levels of greed or fear in the market at a given point in time.

Oscillators are most useful and issue their most valid trading signals when their readings diverge from prices. A bullish divergence occurs when prices fall to a new low while an oscillator fails to reach a new low. This situation demonstrates that bears are losing power, and that bulls are ready to control the market again—often a bullish divergence marks the end of a downtrend.

Bearish divergences signify potential downtrends when prices rally to a new high while the oscillator refuses to reach a new peak. In this situation, bulls are losing their grip on the forex market, prices are rising only as a result of inertia, and the bears are ready to take control again.

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Classes of Divergences

Divergences, whether bullish or bearish in nature, have been classified according to their levels of strength. The strongest divergences are Class A divergences; exhibiting less strength are Class B divergences; and the weakest divergences are Class C. The best trading opportunities are indicated by Class A divergences, while Class B and C divergences represent choppy price action and should generally be ignored.

Class A bearish divergences occur when prices rise to a new high but the oscillator can only muster a high that is lower than exhibited on a previous rally. Class A bearish divergences often signal a sharp and significant reversal toward a downtrend. Class A bullish divergences occur when prices reach a new low but an oscillator reaches a higher bottom than it reached during its previous decline. Class A bullish divergences are often the best signals of an impending sharp rally.

Class B bearish divergences are illustrated by prices making a double top, with an oscillator tracing a lower second top. Class B bullish divergences occur when prices trace a double bottom, with an oscillator tracing a higher second bottom.

Class C bearish divergences occur when prices rise to a new high but an indicator stops at the very same level it reached during the previous rally. Class C bullish divergences occur when prices fall to a new low while the indicator traces a double bottom. Class C divergences are most indicative of market stagnation—bulls and bears are becoming neither stronger nor weaker.

Examples of Bullish and Bearish Divergences

With divergences, traders identify a rather precise point at which the market's momentum is expected to change direction. But aside from that precise moment, you must also ascertain the speed at which you are approaching a potential shift in momentum. Stock and Forex Market trends can speed up, slow down or maintain a steady rate of progress. The leading indicators that you can use to ascertain this speed are:

Stochastic Divergence 

Momentum oscillators generally move in the same direction as price. However, because the momentum oscillators are measuring not just the direction of price change but also the rate of change in price, their direction will diverge from the direction of the price of the asset when the rate of change slows. In other words, when the price is moving higher or lower, so should the oscillator. However, when the speed of that trend slows, the direction of the momentum oscillators will start to diverge from that of price. Those divergences can be valuable leading indicators of a possible trend reversal. For example, slowing momentum, as reflected by these divergences, suggests a trend reversal may becoming. 

Bullish Divergence vs Bearish Divergence

Here’s some explanation of bullish divergence:

  • Lines A and A1: These are examples of how an oscillator typically moves in the same direction as price, in this case reflecting the same downward momentum.
  • Lines A and A2: Even though the USDCAD is moving lower, A2 shows how the stochastic oscillator is suggesting a reversal is coming, as it reflects increasing bullish momentum (or fading bearish momentum). In other words, recent prices have been higher over the period it measures, hence the uptrend in the stochastic that foretells the coming uptrend.
  • Lines B and B2: Again, while the USDCAD itself is moving higher, the momentum of the move is weakening over the dates covered; hence, while the pair itself keeps moving higher, the stochastic starts trending lower, forecasting the coming reversal.

     

Divergence RSI

Divergences signal a potential reversal point because directional momentum does not confirm the price. A bullish divergence occurs when the underlying security makes a lower low and RSI forms a higher low. RSI does not confirm the lower low and this shows strengthening momentum. A bearish divergence forms when the security records a higher high and RSI forms a lower high. RSI does not confirm the new high and this shows weakening momentum. The chart below shows a bearish divergence in August-October. The stock moved to new highs in September-October, but RSI formed lower highs for the bearish divergence. The subsequent breakdown in mid-October confirmed weakening momentum.

Bullish Divergence vs Bearish Divergence

A bullish divergence formed in January-March. The bullish divergence formed with eBay moving to new lows in March and RSI holding above its prior low. RSI reflected less downside momentum during the February-March decline. The mid-March breakout confirmed improving momentum. Divergences tend to be more robust when they form after an overbought or oversold reading.

Before getting too excited about divergences as great trading signals, it must be noted that divergences are misleading in a strong trend. A strong uptrend can show numerous bearish divergences before a top actually materializes. Conversely, bullish divergences can appear in a strong downtrend - and yet the downtrend continues. Chart below shows the S&P 500 stock index with three bearish divergences and a continuing uptrend. These bearish divergences may have warned of a short-term pullback, but there was clearly no major trend reversal.

Bullish Divergence vs Bearish Divergence

MACD Divergence

Divergences form when the MACD diverges from the price action of the underlying security. A bullish divergence forms when a security records a lower low and the MACD forms a higher low. The lower low in the security affirms the current downtrend, but the higher low in the MACD shows less downside momentum. Despite decreasing, downside momentum is still outpacing upside momentum as long as the MACD remains in negative territory. Slowing downside momentum can sometimes foreshadow a trend reversal or a sizable rally.

MACD Divergence

 

A bearish divergence forms when a security records a higher high and the MACD Line forms a lower high. The higher high in the security is normal for an uptrend, but the lower high in the MACD shows less upside momentum. Even though upside momentum may be less, upside momentum is still outpacing downside momentum as long as the MACD is positive. Waning upward momentum can sometimes foreshadow a trend reversal or sizable decline.

A bearish divergence forms when a security records a higher high and the MACD Line forms a lower high. The higher high in the security is normal for an uptrend, but the lower high in the MACD shows less upside momentum. Even though upside momentum may be less, upside momentum is still outpacing downside momentum as long as the MACD is positive. Waning upward momentum can sometimes foreshadow a trend reversal or sizable decline.

Divergences should be taken with caution. Bearish divergences are commonplace in a strong uptrend, while bullish divergences occur often in a strong downtrend. Yes, you read that right. Uptrends often start with a strong advance that produces a surge in upside momentum (MACD). Even though the uptrend continues, it continues at a slower pace that causes the MACD to decline from its highs. Upside momentum may not be as strong, but it will continue to outpace downside momentum as long as the MACD line is above zero. The opposite occurs at the beginning of a strong downtrend.

Understanding divergence in trading is important, but if you want some help, the MetaTrader 5 platform offers a useful Oscillators toolkit and our trainers can provide you the right guidance. Play around in a ​forex demo account and notice how Stochastic, RSI and MACD divergence patterns can make you serious money.

You can test the trade signals of bearish and bullish divergence by creating a Forex EA with our Expert Advisor Generator (14 Days FREE Trial).

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