Signs of Trend Reversal or Continuation
Divergences are a very powerful tool to use when trading cryptocurrencies and are arguably one of the best uses of an oscillator. Divergences can be used with almost any oscillator though you'll most often see them used on RSI, Stochastic RSI, On Balance Volume (OBV), Stochastic or the MACD.
A confirmed divergence shows underlying strength or weakness and can be an early warning sign of a trend reversal or continuation. However, divergences don't always play out immediately and don't confirm reversal or continuation in and of themselves; they should be used in combination with other tools such as price action and strength or resistance. Furthermore, as with any tool the higher time frame the more reliable the signal is.
There are two types of divergences, regular or hidden, and they can either be bearish or bullish. At first they're a bit tricky to spot but with some practice you'll start noticing them everywhere. Master divergences and your trading will improve dramatically.
Regular Divergences
Regular divergences are generally used to indicate the end of a trend or the start of a trend reversal.
Regular Bullish Divergence
A regular bullish divergence typically occurs during a downtrend and can signal a reversal or start of an uptrend. This occurs when price makes a lower low but the oscillator makes a higher high, signalling underlying strength despite the drop in price.
Here Bitcoin is in a downtrend and price continues to drop, setting lower lows. However, RSI and Stochastic RSI are marking higher highs creating a regular bullish divergence. As covered above, a divergence doesn't always play out immediately. Here there are two instances of price making lower lows while the oscillators make higher highs. The first instance results in a period of sideways price action before a further dip. It's during this second, extended bullish divergence that price reverses and an uptrend begins.
Regular Bearish Divergence
A regular bearish divergence typically occurs during an uptrend and can signal a trend reversal or start of a downtrend. This occurs when price makes a higher high but the oscillator makes a lower low, signalling underlying weakness despite the increase in price.
Here price is making a series of higher highs while the oscillators are showing lower lows. As noted before, that does not signal the immediate end of the uptrend. The first confirmed bearish divergence resulted in a minor dip after which Bitcoin reached new highs. However, the bearish divergence persisted and ultimately led to the start of a major downtrend with price dropping from 20k to 11k.
Hidden Divergences
Hidden divergences aren't typically used to spot reversals but instead indicate trend continuation.
Hidden Bullish Divergence
A hidden bullish divergence can signal that a retracement may be short lived and indicate a good entry opportunity to enter a trade or buy the dip during an uptrend. This occurs when price makes a higher low while the oscillator makes a lower low.
As we saw in the example of a regular bearish divergence, the divergence in itself does not always mean the trend is going to reverse. Look back at the former example and now look at this chart - even though there was a Regular Bearish Divergence there was also a hidden bullish divergence in plays. Price dips and then shortly after proceeds to move back up and the uptrend continues.
Hidden Bearish Divergence
A hidden bearish divergence generally occurs during a downtrend and indicates trend continuation is likely. These divergences can be great to spot a false rally or signal an opportunity to short the bounce. Hidden bearish divergences occur when price makes a lower high while the oscillator makes a higher high.
Above, Bitcoin is in a downtrend and price has started to bounce to the upside. However, price has not managed to clear previous highs and both Stochastic RSI and RSI are showing higher highs. The rally becomes a dead cat bounce and the downtrend resumes.
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