Bullish and Bearish Divergences: Reversal Patterns


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Video Transcript:

Hello traders. Welcome to the sixth module of the advanced technical analysis course, oscillators. In this lesson we are going to teach you all about bullish and bearish divergences, what they are, how to spot them and, of course, how to trade them. You need to bear in mind that you can find these divergences using all of the oscillators that we have gone through in the previous lessons. This is why we are teaching you an overall lesson on bullish and bearish divergences.

Now, let’s start by defining what these divergences are. A divergence is a strong signal of reversal in price because directional momentum does not confirm the price movement. As you’ve seen before, the oscillator marks what price is doing at the time, and when the momentum oscillator does not confirm the price movement, we have divergences. These type of setups can be spotted with all oscillators as we already told you.

A bullish divergence occurs when the security makes lower lows, but the oscillator is making higher lows. This is what we were talking about when we said that directional momentum does not confirm the price movement. In a bullish divergence it means that the security is making lower lows, but the oscillator is making higher lows. When we are trading with a bullish divergence, we are looking to go long on a end of down trend.

On the other hand, we have bearish divergences. A bearish divergence occurs when the security makes higher highs, but the oscillator is making lower highs. This is the same thing as a bullish divergence only on the opposite side. At the end of an up move, sometimes you will see that the security will make higher highs, but the oscillator will make lower highs. This means that we are looking to short or to go short when we have confirmation that the divergence is in fact in play.

There are a few rules we need to go through before we go through the actual charts. It’s better to trade divergences at high conflicted areas. This means that you are looking for strong areas of support and resistance to look for these divergences at the end of up moves or down moves.

In order to get an entry in a bullish divergence, we need to take out the previous high. This is normal. Because we are in a down move and we are making lower highs, when we spot a bullish divergence and we want to go long we need to take the previous high for the down structure to be broken and for us to get a confirmation that a divergence is in play.

In a bearish divergence, we need to take out the previous low. This is because we also need a break of the previous up structure for us to get confirmation that the bearish divergence is in play. Remember that bullish and bearish divergences are reversal signals, so we are going to try and counter trend trade. This is why we need a confirmation that the previous structure is broken.

You must use the entry rules of whatever oscillator you are using. If you are using the MACD, you should look for the signal line crossing over or below the MACD line. If you are using the RSI, you might want to look for a return from extreme levels, or a cross below 50. If you are using the stochastic oscillator, you should also look for moves back from extreme levels and the oscillator lines crossing over. In this case, we are going to use the RSI as an example.

This is the osci U.S. dollar daily chart. As you can see here, we are in a down move. This is a very strong move that takes us from 1.0606 to the 0151 level. As you can see here, the oscillator is following what price is doing until we hit this low. When we hit this low, the oscillator makes this low right here. When price makes a lower low, the oscillator makes a higher low, meaning that we are actually shifting trends.

Bullish Divergence

Once we spot the divergence, we need confirmation that the down structure has in fact been broken. We get confirmation when in fact we break with the previous high right here, and when the RSI moves to bull territory, or above the 50 level, so we can go long, because the divergence is in play. As you can see here, price moves all the way up here to test these highs again.

On the other side, a bearish divergence, occurs at the end of an up move. In this case you can see that we are making higher highs and lower highs. When the price makes a higher high right here in this area of resistance, you can see that the RSI makes a lower high giving us a bearish divergence.

Bearish Divergence

We grab the last low before the actual divergence, and when we break below it and the RSI breaks below 50, we are in bear country and can short this currency payer to make a nice little profit on a bearish divergence play.

This is how you trade divergences and how you spot them. As we already told you, you can use any of the oscillators we have gone through on this model to spot divergences. Of course, choosing the oscillator will depend on your trading system and your trading style, but divergences can be found with any of them.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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