How to combine Divergences with cluster charts?
Divergence is a common notion that is found not only in trading, but also in mathematics, biology and other sciences.
In this article you will find out:
What is divergence?
To understand what divergence is, it is better to start with the meaning of the word.
Divergence comes from a Latin word “divergere” which means “to detect a disagreement”.
In trading, divergence refers to a disagreement in dynamics between a price chart and various price indicators.
Let’s consider an example from the euro futures chart, the data was taken from the CME exchange, timeframe = 5 minutes.
There is an RSI indicator, added to the chart (it was chosen only for demonstration without any specific reason).
Pay attention to the disagreement between the dynamics of the price and the indicator:
- on the price chart new highs exceed the previous ones;
- on the indicator chart new highs do NOT exceed the previous ones.
This disagreement is called divergence in trading.
What do divergences mean in trading?
In the case presented above the divergence shows that the upside momentum within the day is presumably exhausted and the price may go down or become flat (neither rising nor declining).
This is called bearish divergence.
When traders spot such a divergence, they may decide to exit a long position (if they had any) and/or open a short position (which can be a risky idea).
Types of divergences
There are a few types of divergences:
- bullish and bearish;
- regular and hidden;
- reversing or indicating a continuation of the trend.
Regular bearish divergence:
- on the price chart new highs are rising;
- on the indicator chart new highs are falling.
This type of divergence signifies that a bearish trend will go down and a possible downward reversal is likely to happen. You can see an example on the above chart.
Hidden bearish divergence:
- on the price chart new highs are falling;
- on the indicator chart new highs are rising.
This type of divergence signifies a continuation of the bearish trend.
Let’s consider an example from the euro futures chart, the data was taken from the CME exchange, timeframe = 30 minutes.
The chart shows that the formation of a higher high on the RSI indicator does not correspond to the price chart where the new high is lower than the previous one.
This hidden bearish (or reverse) divergence that occurs within a downward trend suggests that prices will continue to fall.
Regular bullish divergence:
- on the price chart new lows are falling;
- on the indicator chart new lows are rising.
A regular bullish divergence signifies that a bearish trend will go down and an upward reversal is likely to happen. We will have a look at a detailed example below.
Hidden bullish divergence:
- on the price chart new lows are rising;
- on the indicator chart new lows are falling.
A hidden bullish divergence signifies that a bullish trend will continue.
How to trade divergence?
Despite the fact that divergence formation can be used to obtain trading signals, it is unlikely that the divergence on the price and indicator charts can be a sufficient justification for entering a position.
Let’s have a look at a regular bullish divergence on the E-mini futures chart of the S&P-500 stock index below. The data was taken from the CME exchange, timeframe 10 minutes.
The arrows are showing that the three lows, which are going down on the price chart, correspond to the lows, which are going up, on the RSI indicator chart. This is a triple divergence.
When you see this type of divergence, you can close completely or partially a short position (if you have any). However, long entries will not bring you any profit, you are more likely to lose money.
Let’s suppose you spotted a divergence when the indicator made a second higher low. You went long at the close of the bullish candle (1) and placed a protective stop loss under the previous local low (2). In this scenario, your stop-loss will be triggered in 20 minutes.
Having identified the third higher low on the indicator, you went long at the close of the bullish candle (3) and placed a protective stop-loss under the previous local low (4).
In the best case scenario, the profit from the second long position could compensate for the loss from the first one (but it is important to exit on time). In the worst case scenario (which is the most probable), the loss would increase with the bearish breakout candle at 20:50 (last on the chart).
This example reveals important aspects of using divergence trading.
Advantages and disadvantages of divergences trading
Advantages:
- Easy to understand.
- Every now and then they give good signals which warn of changes in the strength of the trend.
- Work in any markets and timeframes.
Disadvantage 1. Divergences depend on indicators.
There are different indicators: RSI, CCI, Stochastic, Stochastic RSI, MACD, Momentum. The ATAS arsenal includes nearly 100 indicators and each one of them has its own settings. Therefore, divergences may or may not form in the same market. It depends on the indicator you use and its settings.
Different indications on the same prices are a bad sign because you will get a lot of false signals when trading on divergences.
Disadvantage 2. Divergences ignore data on trading volumes.
Divergences between price and oscillators often do not take into account volume data, but this valuable information relates directly to the driving forces in the market: the forces of supply and demand. Usually, traders use only oscillators, derived from the historical price, and ignore the fact that an infusion of funds can make an adjustment and cross out any divergence at any moment.
This disadvantage can be balanced to some extent if you use volume-based indicators to search for divergences. For example, On Balance Volume (OBV).
Let’s have a look at an example on the daily chart of futures for the S&P-500 stock index.
The chart shows how a bullish divergence is formed when the lows, which are going down, on the candles (1) do not match the going down lows on the indicator. Moreover, the OBV indicator forms a local bullish breakout earlier than the price does, thus showing that the trend is changing to bullish.
Money Flow Index is one of the indicators that uses volume values in calculations to search for divergences.
An example of divergence on the Cumulative Delta indicator
Delta is an indicator that shows the difference between market buys and sells on the same bar.
Read more in the article “Delta and Cumulative delta: what are they and how could they help an intraday trader?”
Let’s have a look at the Cumulative Delta indicator that is used to spot divergence on the E-mini chart of the S&P-500 index futures intraday.
We clearly see on the 5 minute time frame that each new downward wave forms a new, lower low of the price (1).
However, we can see the reverse dynamics on the Cumulative Delta indicator – each new low is higher than the previous one (2).
This is a regular bullish divergence which shows that an upward reversal can be expected in the market. Indeed, the Cumulative Delta indicator shows that the thrust of market sell orders is gradually decreasing, so the decision to open a long position in this situation can be made more firmly.
How to improve your divergence trading using cluster charts?
Let’s talk about combining divergence trading with cluster analysis.
The picture below shows the gold futures chart, daily timeframe. The data was taken from the COMEX exchange (part of the CME Group). We chose OBV as an indicator to look for divergences, as it is also related to volume.
Number 1 shows that two peaks are forming on the price chart and the second one is higher than the first one.
Number 2 shows that two peaks are also forming on the indicator chart, however, the second one is much lower than the first one. Thus, we can clearly see the formation of divergence. This is a bearish divergence which warns traders that it is difficult for the price to go up and a decline is likely to occur in the coming days.
But will the recession really happen? Where can you find confirmation? Our answer is on cluster charts.
Number 3 shows what was actually happening at the second peak. We see green clusters – market buys. However, look at the price reaction. The price seems to “bounce down” from the green clusters. Why is it like that?
Green clusters that indicate market buys and the bearish price dynamics (a reaction to buys) suggest that we are dealing with buys of “weak traders”. And/or activation of sellers’ stop-losses set above the 1830 level. This is a sign that important traders are aware of the real bearish trend and take short positions in advance.
The subsequent decline below 1770 shows that the information obtained by the cluster analysis method is more reasoned (as is often the case).
How to start trading?
We hope that the information presented in the article was useful for you, and you are interested in applying divergence and cluster analysis for conducting trading operations in financial markets on your own.
Download ATAS. There are four good reasons for that:
- It’s free and you can continue using the program even after the 14-day trial period.
- You will be able to analyze divergences in the stock, futures and crypto markets.
- There is a demo account built into the ATAS platform, so you can practice trading without risking your real capital.
- The platform offers many benefits for traders who want to trade with easy-to-use cluster charts and useful indicators.
Read our blog and subscribe to our YouTube channel.
Conclusions
Divergence is the fact of disagreement between data. In trading, divergences are tracked between extremums on the price and indicator charts. This is a simple and popular way to identify a trend.
We believe that divergence is not to be relied on exclusively. It would be a better idea to combine it with other tools.
To improve the accuracy of entries and exits in trading, we recommend to combine divergences with modern cluster analysis methods.
Download the free version of ATAS right now! Try a powerful cluster chart analysis tool for stock, futures and crypto markets.
Information in this article cannot be perceived as a call for investing or buying/selling of any asset on the exchange. All situations, discussed in the article, are provided with the purpose of getting acquainted with the functionality and advantages of the ATAS platform.
