Divergence is when an asset price is moving in the opposite direction of a technical indicator. It is often seen as a sign that the current market movement is weakening and losing momentum, hinting at a potential price direction change. If divergence signals that a lower move may follow, then it is known as negative, or bearish, divergence.
When a trader wants to spot bearish divergence, they first need to choose an indicator for analysis. In most cases, traders use momentum oscillators, and the relative strength index (RSI) could be the most popular choice. After that, traders need to look only at price highs and draw a line between two or more tops. When drawing a line, traders should pay more attention to the value of the candlestick bodies, not the wicks. Traders predominantly use higher time frames to find divergences.
Let’s take a look at the following examples to understand how bearish divergence works, and what it looks like.
Strong Bearish Divergence
Strong bearish divergence, which is also known as regular/classic bearish divergence, occurs when the price reaches a higher high but the oscillator makes a lower high. It means that the average momentum is decreasing even when the price is moving higher. Such a situation could be used as a potential signal to go short.
However, support levels may test whether or not there is enough momentum to continue downward movement. In this case, traders may analyze trading volume and other indicators to confirm the potential breakout of support levels.
Medium Bearish Divergence
Medium bearish divergence is found when price makes a double top at the same price level, but the oscillator creates a lower high.
Keep in mind that divergence indicates a potential change in momentum and price movement, but it may not lead to an immediate trend reversal. In the example above, the price first rebounded from the lower level before moving to the major support (red line).
Weak Bearish Divergence
Weak bearish divergence appears when the price reaches a higher high but the oscillator forms a double top. This suggests that the average momentum is not ready to follow the price.
In the chart above, the oscillator reached consecutive divergence, or double top, two times in a row. In this case, traders may analyze each divergence separately, or combined.
As an additional confirmation of a potential bearish signal, traders may find a trend-reversal candlestick pattern (purple) that follows divergence.
Hidden Bearish Divergence
Unlike previous types, hidden bearish divergence occurs during the downtrend and indicates its potential continuation. In this case, the price reaches a lower high but the oscillator moves higher.
Note that divergence may form across more than two highs, meaning divergence may persist for a long time.
Other Ways to Find Bearish Divergence
Divergence can occur between price and any other piece of data. Although RSI can be considered the most popular way to spot divergence on the price chart, there are many other indicators and oscillators that traders can use to uncover potential divergence. For instance, there’s the commodity channel index (CCI), Stochastic, Williams %R, moving average convergence divergence (MACD), and on-balance volume (OBV).
However, none of this means that traders should use a single indicator to spot divergence. If necessary, traders may analyze other indicators to verify whether the asset experiences divergence.
Let’s assume that after finding strong bearish divergence with RSI, a trader decided to confirm it using MACD and Stochastic indicators.
In the chart above, MACD lines also experience divergence with the price at that moment, forming lower highs and indicating a potential price reversal.
As you can see, the Stochastic indicator also shows a lower high, hinting at further downward movement. If bearish divergence is observed using several indicators, it could potentially render the bearish signal more valid.
However, indicators do not always follow each other in terms of divergence. In these cases, traders may use other methods of market analysis to evaluate potential bearish signals.
Divergence could be a strong signal for further price retracement, but it may also experience so-called false positives, or situations when divergence occurs but no trend reversal follows. Furthermore, when divergence does occur, it doesn’t always mean the price will immediately reverse, or reversal will occur soon. Bearish divergence can last for a long time and consist of several highs. Therefore, traders should undertake other forms of analysis to confirm signals offered by divergence.
Disclaimer: For information purposes only. Not investment or financial advice. Seek professional advice. Digital assets involve risk. Do your own research.