How to Trade Classic Bullish Divergence and 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 start going in the opposite direction. For this reason this trading setup is used as a low risk entry method and also as an accurate way of exit out of a trade.

This trading 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 don't 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 identify a profit taking level would be the point where you identify this trading setup.

There are 2 types, based on the direction of the trend:

1. Classic Bullish divergence
2. Classic Bearish divergence

XAUUSD Classic Bullish Divergence

Classic bullish divergence setup forms when price is forming lower lows ( LL ), but oscillator is making higher lows (HL). The example depicted and demonstrated below highlights a picture of this trading setup.

Gold Classic Bullish Divergence

This example uses MACD indicator as a divergence indicator.

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

Classic bullish diverging signal warns of a possible change in the trend from down to up. This is because even though the price went lower the volume of sellers that pushed the price lower was less as depicted by the MACD technical indicator. This shows underlying weakness of the down ward trend.

Classic bearish Trade Divergence Setup

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

Gold Classic Bearish Divergence

This example 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 the indicator. This signal warns of a possible trend reversal.

Classic bearish diverging signal warns of a possible change in the trend from up to down. This is because even though the price went higher the volume of buyers who pushed the price higher was less as depicted by the MACD indicator. This indicates underlying weakness of the upward trend.

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

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

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

Examples of Moving Average Crossover Technique Strategy

Once the divergence trading 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 upwards cross over signal, while for a bearish classic divergence signal the trader should wait for the Moving average crossover system to give a downward bearish cross-over trading signal.

By combining the classic divergence trading signals with other indicators this way, a trader will be able to avoid whipsaws when it comes to trading the classic diverging signals, because the trader will wait until 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.