Classic Bullish Stock Divergence vs Classic Bearish Divergence

In trading, classic divergence is used as a possible signal for a trend reversal and is used by traders when looking for an area where price could reverse and begin going in the opposite market direction. For this reason this stock indices setup is used as a low risk entry method and also as an accurate way of exit out of a trade.

This strategy is a low risk technique to sell near the top or buy near the bottom, this makes the risk on your trades are very small relative to the potential reward. However, this is one technique with very many whipsaws and most traders do not recommend using it.

Divergence in Trading is also used to predict the optimum point at which to exit a trade. If you already have an open trade that's already profitable, a good way to spot a profit taking level would be the point where you spot this trade setup.

There are two types, based on the direction of the Stock Indices trend:

1. Classic Bullish divergence
2. Classic Bearish divergence

Stock Classic Bullish Divergence

Classic bullish divergence set-up occurs when price is making lower lows ( LL ), but the oscillator is making higher lows (HL). The example illustrated below shows a picture of this trade setup.

Indices Classic Bullish Divergence

This examples uses MACD indicator as a divergence indicator.

From the above example the price made a lower low(LL) but the technical indicator made a higher low(HL), this highlights there's a divergence between the price and indicator. This signal warns of a possible trend reversal.

Classic bullish diverging signal warns of a possible change in trend from downwards to upwards. This is because even though the price moved lower the volume of sellers that moved price lower was less as illustrated by the MACD technical indicator. This shows underlying weakness of the downward trend.

Classic bearish Stock Divergence Setup

Classic bearish divergence setup occurs when price is making a higher high ( HH ), but the oscillator is lower high (LH). The image below shows an example of the setup.

Stock Classic Bearish Divergence

This examples also uses MACD indicator

From the above example the price made a higher high(HH) but the indicator made a Lower High(LH), this highlights there's a divergence between the price and indicator. This signal warns of a possible trend reversal.

Classic bearish diverging signal warns of a possible change in the trend from upwards to downwards. This is because even though the price moved higher the volume of buyers that moved price higher was less as portrayed by the MACD indicator. This shows underlying weakness of the upwards trend.

In the example above, if you had used divergence setup to trade you would have gotten good signals to enter or exit the trades at an optimal point. However, divergence signals just like other indicators, also is prone to whip-saws. That is why it's always good to confirm the diverging signals with other technical indicators such as the RSI, Moving Averages & Stochastic Oscillator.

A good indicator to combine classic diverging setups is the stochastic oscillator and wait for the stochastic lines to move in direction of the divergence signal so as to confirm the signal.

Another good technical indicator to combine with is the moving average technical indicator, in this indicator a trader should use the MA Cross Over System

Example of MA Crossover Strategy Method Strategy Method

Once the divergence signal is given, a trader will then wait for the Moving average crossover system to give a signal in the same direction, if there is a classic bullish setup, a trader will wait for the moving average system to give an upward crossover signal, while for a bearish classic divergence signal the trader should wait for the Moving average crossover system to give a downward bearish crossover signal.

By combining the classic divergence signals with other indicators this way, a trader will be able to avoid whip-saws when it comes to trading the classic diverging signals, because the trader will wait til the market has actually reversed and is already moving towards this direction, hence the trader will not fall into the trap of picking market tops and bottoms.