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Concept of Divergence
Previously we have mentioned Moving Average Convergence and Divergence (MACD) is a popular lagging indicator. Now we will learn (MACD) indicator, but before we begin, it is essential to understand the concept of 'Divergence' that we will learn here in this section. So let us get started.
Divergence occurs when the price of the stock and indicator are moving in opposite directions. They do not match with each other.
What is Positive and Negative Divergence?
Negative divergence occurs when the price is in an uptrend and an indicator like the moving average convergence divergence (MACD), price rate of change (ROC) or relative strength index (RSI) moves downward. It is a condition where Price makes higher tops and higher bottoms whereas Indicators fail to do so. They make lower tops and lower bottoms.
Positive divergence occurs when the price is in a downtrend but the indicator starts to rise. It is a condition where Price makes lower tops and lower bottoms whereas Indicators fail to do so. They make higher tops and higher bottoms. These are usually reliable signs as they predict prices are going to reverse.
What is Hidden Divergence?
We can understand it by understanding the difference between the regular and hidden divergence.
Regular divergence is a trend reversal signal whereas hidden divergence is a trend continuation signal.
Hidden Bullish Divergence
- During an uptrend.
- Once price makes a higher Low, but oscillator makes a lower Low.
- The trend should continue to the upside.
Hidden Bearish Divergence
- During a downtrend.
- Once price makes a lower high, but oscillator makes higher high
- The trend should continue to the downside.
Difference between Regular and Hidden Divergence:
Hidden divergence mainly signals the continuation of the trend whereas regular divergence signals trend reversals.
Suppose the trend of the stock is upward, but the prices have started falling whereas the RSI is making a higher high, then a trader can spot this as a positive hidden divergence, and may increase his quantity by buying on the dip.
Now, the prices are increasing, but suddenly RSI starts making a lower low, then the trader should become cautious as a bearish regular divergence is being made, and there could be price reversal.