Deviating from technical analysis, how to identify potential reversal signals.

1. What is divergence?

Divergence is a commonly used Concept in Technical Analysis. As the name suggests, divergence generally refers to the phenomenon where price movements are inconsistent with Technical Indicator, indicating a weakening momentum and a potential reversal in the market.

Divergence occurs frequently and can happen across different Technical Indicators and various timeframes. Therefore, in practice, divergence often receives significant attention from traders and is a part of systematic Trade strategy.

Divergence is generally divided into three categories: bottom divergence, top divergence, and hidden divergence.

Bottom divergence occurs when the price breaks below a previous low, but the Technical Indicator is above the previous low, indicating a weakening downward momentum and a potential upward reversal in price.

Top divergence occurs when the price breaks above a previous high, but the Technical Indicator is below the previous high, indicating a weakening upward momentum and a potential downward reversal in price.

Bottom divergence and top divergence are collectively referred to as 'regular divergence' and are widely used to assess potential trend reversals. Hidden divergence, on the other hand, assesses potential trend continuations, but general investors may overlook this point.

Hidden divergence can occur in two scenarios: one is in an upward trend where the price lows are moving up while the Technical Indicator lows are moving down; the second is in a downward trend where the price highs are moving down while the Technical Indicator highs are moving up. Hidden divergence suggests that price momentum is strong and the trend may continue.

2. How to identify divergence signals?

Divergence signals often appear in various momentum oscillators, such as the commonly used MACD indicator and RSI indicator.

It is important to note that divergence signals that occur in longer time frames are often more reliable, while in shorter time frames, they tend to frequently issue false signals.

In terms of regular divergence, investors can compare the two adjacent price highs in an uptrend or the two adjacent price lows in a downtrend to see if there is a synchronization phenomenon in the technical indicator highs/lows at the corresponding time points. If the price does not synchronize with the technical indicator, it releases a divergence signal.

Specifically, a bottom divergence usually occurs during a longer downtrend, when the price makes a new low but the technical indicator does not, instead showing an upward momentum. Conversely, a top divergence usually occurs during a longer uptrend, when the price makes a new high but the technical indicator does not, instead showing a downward momentum.

In practice, it is best for investors to use multiple technical indicators simultaneously to assess divergence, rather than relying on a single indicator. Additionally, investors should view divergence as a warning signal rather than a trading signal. The specific timing for trading still needs to be confirmed comprehensively in conjunction with other technical analysis methods.

Divergence is particularly useful in certain market environments, such as trending markets, but it is relatively less effective in sideways movements.

Compared to regular divergence, hidden divergence is termed 'hidden' because this phenomenon is not obvious and is easily overlooked by investors. However, in practice, we can better address this issue using Trendlines.

With the assistance of Trendlines, investors can compare two adjacent price lows in an uptrend or two adjacent price highs in a downtrend to see if the corresponding Technical Indicator lows/highs are synchronized. If they are not synchronized, it reveals a hidden divergence signal. Hidden divergence indicates that the current trend is slowing down and might suggest that the market has briefly entered an overbought or oversold state, which actually provides investors with a potential "entry" opportunity to follow the trend.

3. Case Analysis

Figure 1 shows a downward trend where the price continuously creates new lows. At the same time, a double bottom pattern seems to appear at the bottom of the market. Although the price is declining, some momentum oscillators did not create new lows in sync, instead showing a phenomenon of rising lows, such as the MACD Indicator and RSI Indicator.

This is a relatively obvious bottom divergence signal, suggesting that the downward price momentum is gradually fading and the market may experience a reversal.

Figure 2 shows a long upward trend where investors can connect several price lows to draw an upward Trendline. Note that during the upward trend, the hidden divergence signal appears where the price lows are rising but the Technical Indicator lows are falling.

Hidden divergence means that during the price pullback process, although the Technical Indicators appear relatively weak, the price trend remains resilient. Therefore, from a trend-following perspective, the price pullback provides investors with potential entry opportunities, especially when it touches the upward Trendline and finds support.

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This content discusses technical analysis; other methods, including Fundamental Analysis, may provide different perspectives. The examples provided are for illustrative purposes only and do not reflect expected results.

All investments involve risks, including the potential loss of principal, and there is no guarantee that any investment strategy will be successful.