Babypips’ article on Hidden Divergence

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  1. Hidden Divergence: A Beginner’s Guide Based on Babypips.com

Hidden Divergence is a powerful concept in Technical Analysis that can provide valuable insights into potential trend continuations. It’s a bit more subtle than regular (or classic) divergence, and often overlooked by novice traders. This article, heavily informed by the excellent resources at Babypips.com, will break down hidden divergence, explaining what it is, how to identify it, how to trade it, and its limitations. We will aim for a comprehensive understanding suitable for beginners while equipping them with the knowledge to explore further.

What is Divergence? A Quick Recap

Before diving into hidden divergence, let's briefly revisit the concept of divergence in general. Divergence occurs when the price action of an asset and a technical indicator move in opposite directions. This suggests a weakening of the current trend. There are two main types of divergence:

  • **Regular (Classic) Divergence:** This is the more common type. It signals a *potential* trend reversal. It happens when price makes higher highs (in an uptrend) or lower lows (in a downtrend), but the indicator makes lower highs or higher lows, respectively.
  • **Hidden Divergence:** This signals a *potential* trend continuation. It's the opposite of regular divergence. Price makes lower highs (in an uptrend) or higher lows (in a downtrend), but the indicator makes higher highs or lower lows, respectively.

This article focuses specifically on the latter: Hidden Divergence.

Understanding Hidden Divergence

Hidden divergence is a signal that the current trend is likely to continue, even if there's a temporary pullback or correction. It suggests that the underlying momentum is still strong, despite the price action appearing to hesitate. The key is understanding *why* this happens.

Let's break down the two scenarios:

  • **Hidden Bullish Divergence (Uptrend):** This occurs in an established uptrend. Price makes a *lower high* (a peak that's lower than the previous peak) but the indicator makes a *higher high* (a peak that's higher than the previous peak). This suggests that buyers are still in control, even though the price didn’t reach a new high. The indicator's strength indicates continued buying pressure is likely. It’s a signal to look for buying opportunities. Consider this in conjunction with Support and Resistance levels.
  • **Hidden Bearish Divergence (Downtrend):** This occurs in an established downtrend. Price makes a *higher low* (a trough that's higher than the previous trough) but the indicator makes a *lower low* (a trough that's lower than the previous trough). This suggests that sellers are still in control, even though the price didn’t reach a new low. The indicator’s weakening suggests continued selling pressure is likely. It’s a signal to look for selling opportunities. Understanding Trend Lines is crucial when identifying this divergence.

Identifying Hidden Divergence: A Step-by-Step Guide

Identifying hidden divergence requires careful observation of both price action and an indicator. Here's a step-by-step guide:

1. **Identify the Trend:** First, determine the prevailing trend. Is it an uptrend or a downtrend? Use tools like Moving Averages to help confirm the trend. 2. **Choose an Indicator:** Select a suitable indicator. Popular choices include: 

   * **Relative Strength Index (RSI):** A momentum oscillator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions.  Investopedia RSI
   * **Moving Average Convergence Divergence (MACD):** A trend-following momentum indicator that shows the relationship between two moving averages of prices. Investopedia MACD
   * **Stochastic Oscillator:**  A momentum indicator comparing a particular closing price of a security to a range of its prices over a given period. Investopedia Stochastic
   * **Commodity Channel Index (CCI):** A momentum-based oscillator used to identify cyclical trends. Investopedia CCI

3. **Look for Lower Highs (Uptrend) or Higher Lows (Downtrend):** Examine the price chart for lower highs in an uptrend or higher lows in a downtrend. These are the key price movements to focus on. 4. **Observe the Indicator:** Simultaneously, observe the chosen indicator during the same timeframe. Look for higher highs in the indicator when price makes lower highs (uptrend) or lower lows in the indicator when price makes higher lows (downtrend). 5. **Confirm the Divergence:** Ensure that the divergence is clear and significant. Minor fluctuations may not be reliable signals. The peaks/troughs on the price chart and the indicator should be reasonably aligned. 6. **Consider the Timeframe:** Hidden divergence is more reliable on higher timeframes (e.g., daily, weekly) than on lower timeframes (e.g., 1-minute, 5-minute). Longer timeframes offer a broader perspective and filter out noise. Time Frame Analysis is vital.

Trading Hidden Bullish Divergence (Uptrend)

Let's illustrate with an example. Imagine a stock is in a clear uptrend. The price rallies to a high of $50, then pulls back to $48, forming a lower high. However, the RSI, during the same period, rises to a higher high than its previous peak. This is a hidden bullish divergence.

Here's how you might trade it:

  • **Entry Point:** Wait for the price to show signs of resuming its uptrend, such as breaking above a recent swing high or a short-term resistance level. A pullback after the divergence is often a good entry point.
  • **Stop-Loss:** Place your stop-loss order below the recent higher low formed during the pullback. This protects your capital if the trend reverses.
  • **Take-Profit:** Set your take-profit target based on previous resistance levels, Fibonacci extensions, or a risk-reward ratio that suits your trading style (e.g., 1:2 or 1:3). Risk Management is paramount.

Consider using additional confirming indicators, such as volume, to strengthen the signal. Increasing volume during the rally after the divergence can confirm buyer interest. Volume Analysis is a helpful addition.

Trading Hidden Bearish Divergence (Downtrend)

Now let’s look at a downtrend. A stock is falling. The price bounces to a high of $30, forming a higher low. However, the MACD, during the same period, falls to a lower low than its previous trough. This is a hidden bearish divergence.

Here's how you might trade it:

  • **Entry Point:** Wait for the price to show signs of resuming its downtrend, such as breaking below a recent swing low or a short-term support level. A bounce after the divergence is often a good entry point.
  • **Stop-Loss:** Place your stop-loss order above the recent lower high formed during the bounce.
  • **Take-Profit:** Set your take-profit target based on previous support levels, Fibonacci extensions, or a risk-reward ratio.

Again, confirm the signal with other indicators. For example, decreasing volume during the rally after the divergence can confirm seller interest. Chart Patterns can also provide additional confirmation.

Limitations of Hidden Divergence

While hidden divergence is a valuable tool, it's not foolproof. Here are some limitations to be aware of:

  • **False Signals:** Like all technical indicators, hidden divergence can generate false signals. The price may not always continue in the expected direction.
  • **Subjectivity:** Identifying divergence can be subjective. Different traders may interpret the same chart differently.
  • **Time Lag:** Indicators are lagging indicators, meaning they are based on past price data. They may not always accurately predict future price movements.
  • **Market Noise:** Short-term market fluctuations can create false divergence signals. Using higher timeframes can help mitigate this issue.
  • **Context is Key:** Hidden divergence should not be used in isolation. It's best used in conjunction with other technical analysis tools and fundamental analysis. Consider the overall Market Sentiment.
  • **Requires Practice:** Accurately identifying and interpreting hidden divergence takes practice and experience. Backtesting your strategies is highly recommended.

Combining Hidden Divergence with Other Tools

To improve the reliability of your trading signals, combine hidden divergence with other technical analysis tools:

  • **Support and Resistance:** Look for hidden divergence near key support and resistance levels. This can provide additional confirmation.
  • **Trend Lines:** Use trend lines to identify the direction of the trend and to confirm the divergence signal.
  • **Fibonacci Retracements:** Combine hidden divergence with Fibonacci retracement levels to identify potential entry and exit points. Investopedia Fibonacci
  • **Chart Patterns:** Look for hidden divergence within the context of chart patterns, such as flags, pennants, or triangles. Candlestick Patterns can offer additional clues.
  • **Volume Analysis:** Confirm the divergence signal with volume analysis. Increasing volume during a continuation move strengthens the signal.
  • **Moving Averages:** Use moving averages to confirm the trend and to identify potential support and resistance levels. Exponential Moving Average (EMA) is a popular choice.

Advanced Considerations

  • **Multiple Timeframe Analysis:** Analyze hidden divergence on multiple timeframes to get a more comprehensive view of the market.
  • **Indicator Settings:** Experiment with different indicator settings to find the ones that work best for your trading style and the specific asset you are trading.
  • **Hidden Divergence and Elliott Wave Theory:** Hidden divergence can be used to confirm wave patterns within the framework of Elliott Wave Theory. Investopedia Elliott Wave
  • **Hidden Divergence and Harmonic Patterns:** Combining hidden divergence with harmonic patterns can offer high-probability trading opportunities. Investopedia Harmonic Patterns

By understanding the nuances of hidden divergence and combining it with other analytical tools, traders can significantly improve their ability to identify potential trend continuations and make informed trading decisions. Remember that consistent practice and a solid Trading Plan are essential for success.


Technical Indicators Chart Analysis Forex Trading Stock Trading Trading Psychology Candlestick Charts Trend Following Support and Resistance Moving Averages Risk Management

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