Divergence represents a distinctive pattern observed on cryptocurrency price charts, serving as an indicator of an impending trend reversal. Classic divergence typically emerges towards the conclusion of an existing trend, whereas hidden divergence tends to manifest during the consolidation phase at the end of a trend.
Both forms of divergence are commonly encountered on cryptocurrency charts, providing vigilant traders with valuable cues for identifying promising investment prospects.
Understanding Divergence in Technical Analysis
Divergence is a crucial pattern within technical analysis that manifests on price charts when the price of a cryptocurrency asset moves counter to a technical indicator or contradicts other data. It serves as an early warning that the current trend may be losing its momentum and could potentially reverse.
Divergence acts as a precursor to potential price movements, be they positive (bullish) or negative (bearish). Positive divergence, often referred to as bullish divergence, suggests an imminent price rally. Conversely, negative divergence, or bearish divergence, hints at an impending price decline.
When traders identify positive divergence on their charts, those who are currently short on the asset may consider closing their positions. Meanwhile, traders who are either neutral or have long positions may contemplate adding to their holdings or entering new long positions, as positive divergence suggests an upcoming rally.
There are two primary types of divergence that signal an impending bullish rally. The more common one is regular or classic divergence, while the somewhat trickier-to-identify hidden divergence can be a potent pattern, serving as a strong indicator of a shifting trend.
Understanding Regular or Classic Divergence
Regular divergence occurs when the price of a cryptocurrency forges ahead, establishing higher highs, while concurrently, the indicator records lower highs.
In the depicted illustration, Bitcoin continuously attains new all-time highs in its price trajectory. However, the Relative Strength Index (RSI) indicator paints a different picture by consistently forming lower highs. This incongruence serves as a bearish signal for market momentum and hints at an impending transition from an upward trend to a downward one.
Conversely, this phenomenon can manifest in the opposite direction.
In the above instance, Bitcoin undergoes a correction phase, generating a sequence of lower lows in price. Nevertheless, the Moving Average Convergence Divergence (MACD) indicator charts higher lows, indicating that the downward momentum has waned. This sets the stage for an impending bullish rally, which, in this case, propels Bitcoin to surge by approximately 20% within a span of just a few weeks.
Understanding Hidden Divergence
Hidden divergence emerges when the price of a cryptocurrency forms a higher low, while simultaneously, the indicator registers a lower low. Typically, hidden divergence can be further categorized into bullish or bearish hidden divergence.
For instance, bullish hidden divergence occurs during a correction within an uptrend when the asset's value establishes a higher low. However, the oscillator continues to indicate a lower low. In such cases, this often signifies a continuation of the bullish trend and prompts traders to consider taking profit.
On the contrary, bearish hidden divergence entails the opposite scenario. Here, the asset's value forms a lower high, while the oscillators indicate a higher high. This acts as a signal for an impending trend reversal, prompting traders to set stop-loss orders and consider selling their positions promptly.
In the provided image, Ethereum undergoes consolidation and gradually moves sideways, forming a higher low in its price trajectory. Concurrently, the stochastic indicator reveals a lower low. This alignment indicates a bullish hidden divergence, signaling an imminent rally. As anticipated, Ethereum subsequently experiences a nearly 90% surge over the next couple of weeks.
Hidden divergence can also serve as an indicator of a more profound correction.
Following a feeble recovery from a correction in May 2021, Ethereum traces a hidden bearish divergence pattern. While Ethereum records a lower high in price, the MACD indicator displays a higher high. This suggests that a continuation of the downtrend may be on the horizon. Shortly afterward, Ethereum indeed experiences a further 35% decline.
Choosing Between Regular and Hidden Divergence
The distinction between regular and hidden divergence is subtle but significant. Regular divergence is typically identified at the conclusion of an extended trend and signals the onset of a new corrective phase. Conversely, hidden divergence is typically discovered at the end of a consolidation phase, indicating that the consolidation is likely to conclude in favor of the original trend's direction.
What Sets Hidden Divergence Apart?
Hidden divergence distinguishes itself from regular divergence primarily based on its occurrence within an existing trend. This unique pattern emerges when a consolidation phase is nearing its end within the larger trend, earning it the name "hidden" due to its subtlety, often escaping the untrained eye.
For instance, consider Bitcoin's robust uptrend shown above. In the midst of this upward trajectory, we encounter two instances of bullish hidden divergence. The first instance transpires on February 4, 2021. Here, the RSI indicator forms a lower low, while Bitcoin's price crafts a higher low. This serves as an indicator that the brief consolidation phase is concluding, with Bitcoin poised to ascend further.
Between February 10 and February 14, another consolidation period occurs. Once more, the RSI exhibits a lower low, while Bitcoin's price establishes a higher low. This hidden divergence signifies the conclusion of that minor correction, propelling Bitcoin into another rally.
However, as the trend exhausts itself, regular bearish divergence enters the scene, hinting at an imminent downturn. Starting from February 19 to February 21, Bitcoin's price records a succession of higher highs. Simultaneously, the RSI charts lower highs, highlighting dwindling momentum and foreshadowing a reversal. Consequently, Bitcoin undergoes a 25% correction.
It's worth noting that hidden divergence can manifest in both bullish and bearish directions. The examples above, featuring Bitcoin, vividly illustrate instances of bullish hidden divergence.
Knowledgeable traders can also utilize hidden bearish divergence to assist them in identifying when a trend may persist in a downward direction. This proves particularly valuable in navigating the cryptocurrency markets during corrective phases when uncertainty looms regarding the depth of the correction.
Above, during the latter part of March 2021, as Bitcoin experiences a corrective descent, bearish hidden divergence emerges. The chart reveals a higher high on the RSI while simultaneously depicting a lower high in Bitcoin's price within the same timeframe. This discrepancy serves as an early warning sign of impending losses. Shortly thereafter, Bitcoin's price declines by approximately 12% over the course of two days.
How to Identify Hidden Divergence
Recognizing hidden divergence can pose a challenge for those new to technical analysis, but with practice, you can become adept at spotting and leveraging this pattern to your advantage. Hidden divergence, as well as regular divergence, can be observed across various time frames on cryptocurrency charts, providing ample opportunities for practice and application.
A crucial element for identifying divergence is the use of a technical indicator. Most oscillators or indicators can be employed for this purpose. However, it's essential to note that adding multiple oscillators to your chart doesn't necessarily result in a more reliable signal. Instead, select the oscillator or charting tool that you feel most comfortable with. Regardless of your choice, the same indicator can assist you in identifying both regular and hidden divergence.
In previous examples, we used the Relative Strength Index (RSI). In the following instances, we'll demonstrate how to identify hidden divergence using the stochastic oscillator and the Moving Average Convergence Divergence (MACD), two other commonly used tools for detecting divergence.
Hidden Divergence With MACD
Let's begin with the MACD indicator, which comprises three components:
- MACD line
- MACD signal line
When employing the MACD to identify divergences, any of these three components can be used, and you don't necessarily need all of them to spot divergence effectively. For the examples that follow, we will concentrate on the MACD line, and I recommend increasing its thickness on your chart for improved visibility.
The first step is to ascertain the prevailing trend direction. If the trend is upward, you should be on the lookout for bullish hidden divergence, characterized by the MACD line forming a lower low while the price establishes a higher low. Conversely, if the trend is downward, search for bearish hidden divergence, where the MACD line records a higher high while the price marks a lower high.
Here's an illustration featuring a 1-hour price chart from March 2021. After reaching a low point on March 25, Bitcoin initiated a rally. Between March 27 and 28, a consolidation phase unfolded. On March 28, the MACD line exhibited lower lows compared to its March 27 values, while Bitcoin's price remained higher. This scenario signaled the potential for another rally. After the consolidation concluded, Bitcoin indeed surged by approximately 9% over the subsequent two days.
Detecting Hidden Divergence with Stochastics
The stochastic oscillator (sometimes referred to as the slow stochastic) is a three-input oscillator that generates two lines. I commonly use the input values of 15-5-5, but 14-3-3 can also be effective.
To enhance visibility, you can thicken the %K line on your charts.
In the illustration above, we observe Ethereum locked in a downtrend on a 1-hour chart from June 2021. Between June 15 and 17, hidden bearish divergence becomes apparent as the stochastic oscillator forms a higher high while Ethereum charts a lower high. This pattern suggests that the consolidation phase following the previous downtrend is concluding, potentially leading to further declines. In hindsight, we can see that Ethereum indeed experienced a rapid price correction, shedding about 20% over the following two days.
Applying Hidden Divergence in Crypto Technical Analysis
Mastering the identification of hidden divergence patterns need not be a daunting task, especially when you realize how frequently these patterns appear on cryptocurrency charts. Now that you've identified the pattern, what should you do next? Follow this step-by-step guide to set up your trades effectively.
Step 1: Filter Your Trades
Hidden divergence serves as a pattern that signifies the conclusion of price consolidation and indicates a continuation of the preceding trend, particularly with assets like Bitcoin. To maximize the potential of your trade, it's essential to seek out hidden divergence patterns within the broader trend context.
For instance, when the overarching trend is upward, focus on identifying bullish hidden divergence. When you spot this bullish hidden divergence pattern, view it as a signal to buy. Conversely, during an uptrend, disregard bearish hidden divergence patterns. In a downtrend, adopt the reverse strategy by searching for bearish hidden divergence and ignoring bullish patterns. The most reliable signals arise when the hidden divergence pattern aligns with the direction of the larger trend.
Step 2: Place Your Stop Loss
Once you've identified a hidden divergence trade that harmonizes with the prevailing trend, it's time to define the trade's parameters. Divergence patterns excel at forecasting upcoming trend changes, but they can be less precise in predicting the timing of such changes. Consequently, it's crucial to allow your trade some leeway to account for regular market fluctuations, preventing unwarranted trade stop-outs.
After you've pinpointed the hidden divergence, position your stop loss just beyond the most recent extreme swing price. In the case of bullish hidden divergence, place the stop loss just below the swing low corresponding to the buy signal. For bearish hidden divergence, situate the stop loss just above the swing high that aligns with the sell signal.
Step 3: Define Your Target
As you're undoubtedly aware, cryptocurrency markets can exhibit astonishing rates of trend movement. Some traders, tempted by the allure of boundless profits, may venture into crypto trading without a clear exit plan. However, I'd recommend adopting a different approach.
If you're trading on shorter-term charts, such as 1-hour or 2-hour intervals, consider establishing a target where you can either partially or entirely exit your trade. A practical guideline is to target a distance at least twice the span between your stop loss and entry point. For example, if your stop-loss is set at 100 ETH, aim for a target of at least 200 ETH. In cases of favorable price movements, remain vigilant for the emergence of classic divergence, which may signal an untimely end to the trend.
Cons of Hidden Divergence
Hidden divergence patterns may become more familiar with practice and appear on many cryptocurrency charts, but it's crucial to acknowledge several limitations:
- Real-Time Identification Challenges: While these patterns are evident in hindsight, they can prove challenging to spot in real-time. This difficulty arises because market emotions can cloud judgment, causing excitement over what initially seems like a bullish upturn, only to later discover it was a bearish hidden divergence setup. It's essential to maintain emotional discipline and strive for an objective analysis, free from emotional bias.
- Late-Trend Appearance: Hidden divergence patterns that manifest late in a trend may lead to less reliable risk-to-reward ratios. By the time the price diverges from the oscillator, much of the trend may have already transpired. This late entry can result in less favorable trade pricing.
- Smaller Cryptocurrency Markets: Smaller cryptocurrencies may exhibit less reliable price patterns compared to larger markets like Bitcoin and Ethereum. These smaller markets tend to have fewer participants, making them susceptible to higher volatility and occasional erratic price movements.
Bullish and bearish hidden divergences are potent patterns typically observed at the conclusion of consolidation phases, signifying a continuation of the primary trend. They are commonly encountered within cryptocurrencies like Bitcoin and Ethereum, making them accessible for learning.
However, identifying these patterns in real-time can present challenges, and late recognition within a trend can lead to less favorable trading conditions. The key to successful hidden divergence trading lies in filtering trades in alignment with the broader trend, maintaining emotional discipline, and utilizing trend-following momentum indicators to validate signals. Always consider the overall market sentiment when trading hidden divergence patterns.