Bullish divergence a situation in which an indicator reveals a likely bullish move but price trends downward Persistent discrepancies are in fact the opposite of bearish signals. Despite their easy application and general information power, commercial oscillators are usually misunderstood in the commercial industry, given their close relationship with momentum. At the most basic level, momentum is actually a way of assessing the relative level of greed or fear on the market at any given time.
Exhaustion a momentum leading to trend reversals
The most reliable trade signal form RSI (relative strength index) comprises divergence, which technically signals the end of a trend. A divergence manifests in the case that RSI does not move in the same direction as that of the market. Divergence is highly helpful to give out-trend reversals. There are two types of divergence:
- bullish divergence and
- bearish divergence.
The first feature (bullish/bearish) state of the divergence relates to the RSI (relative strength index). For instance, a bullish divergence means rising RSI while prices are falling. A bullish divergence occurs when there is a clear downtrend in the market price of the asset while the RSI starts to increase; showing a clear reversal in the trend to drift up. Under bullish divergence, the trading strategy is to buy. A bearish divergence manifests when there is a clear uptrend in the market while the RSI starts to decrease; showing a clear reversal in the trend to move down. Under bearish divergence, the trading strategy is to sell
Bullish and bearish Divergences Give the strongest buy signals: Divergences between RSI and price do not give the strongest buy and sell signals although these tend to occur at major tops and bottoms. They show up when the trend is weak and ready to reverse. While this is theoretically true, in actual fact it is very difficult to trade divergences. The reason for this is that the market continues to move up long after the bearish divergence s visible on the charts. So, too, is the case with a bullish divergence. What these divergences help in is providing a warning signal that the trend is weakening. Accordingly, at such Times stops need to be tightened and profits protected.
Bearish divergence a situation in which an indicator reveals a likely bearish move but price trends upward.
Triple bullish or bearish divergences
These consist of three price tops and their oscillator tops, or their price bottoms and their oscillator bottoms, They are even stronger than the regular divergences. But again, do not buy based on divergence alone.
Bullish vs. bearish
Option investors will seek to establish positions based on their market attitude. Options investors are either bullish or bearish:
- Bullish - Investors who believe that a stock price will increase over time are said to be bullish. Investors who buy calls are bullish on the underlying stock. That is, they believe that the stock price will rise and have paid for the right to purchase the stock at a specific price known as the exercise price or strike price. An investor who has sold puts I also considered to be bullish on the stock. The seller of a put has an obligation to buy the stock and, therefore, believes that the stock price will rise.
- Bearish – investors who believe that a stock price will decline are said to be bearish. The seller of a call has an obligation to sell the stock to the purchaser at a specified price and believes that the stock price will fall and is therefore bearish. The buyer of a put wants the price to drop so he or she can sell the stock at a higher price to the seller of the put contract. An investor who has bought puts I also considered to be bearish on the stock.
Examples of Bullish divergence
- Moving Average Convergence/Divergence (MACD): This is one of the most common examples of bullish divergence. It is a technical indicator that uses the difference between two moving averages of prices to identify a potential trend reversal. The MACD line (the 12-day exponential moving average minus the 26-day exponential moving average) crosses above the signal line (the 9-day exponential moving average of the MACD line). This indicates that the trend is likely to reverse from bearish to bullish.
- Relative Strength Index (RSI): This is another example of bullish divergence. The RSI is a technical indicator that uses price data to measure the strength of a trend. When the RSI falls below a certain level (typically 30 or 40), it indicates that the trend is bearish. When the RSI then moves up and crosses back above the level, it indicates that the trend has reversed and is now bullish.
- Price Patterns: Price patterns can also be used to identify potential bullish divergence. Examples of such patterns include double bottoms and inverted head and shoulders. Double bottoms occur when the price of an asset falls to a certain level twice and then reverses course, indicating a potential reversal in the trend. Inverted head and shoulders patterns occur when the price of an asset falls to a certain level three times, forming a “head and shoulders” pattern, and then reverses course. Both of these patterns indicate a likely trend reversal from bearish to bullish.
Advantages of Bullish divergence
Bullish divergence is a situation in which an indicator reveals a likely bullish move but price trends downward. It can be a great opportunity to enter the market as it often signals a trend reversal. Here are the advantages of bullish divergence:
- Bullish divergence signals a potential trend reversal, which can be a great opportunity to open a long position.
- It can be used as an early warning sign of a possible trend reversal and can help traders to enter the market before the trend changes.
- It can be used to confirm the strength of the trend and to determine the optimal entry and exit points.
- It can also be used as a confirmation tool when combined with other technical indicators.
- It can help traders identify overbought and oversold conditions and act accordingly.
Limitations of Bullish divergence
Bullish divergence is a situation in which an indicator reveals a likely bullish move but the price trends downward. Despite being a useful tool for predicting potential market movements, there are several limitations to using bullish divergence. These limitations include:
- False signals: Bullish divergence can generate false signals due to the presence of noise in the data. This can lead to erroneous assumptions about the direction of prices.
- Timing: Bullish divergence is not a reliable indicator of when the price will turn and begin to rise. It only indicates that the price could rise in the future.
- Signal lag: Bullish divergence can provide a signal of a potential price increase, but it can take a long time to manifest in the market. This can be difficult to manage for short-term traders.
- Interpreting data: Bullish divergence can be difficult to interpret due to the complexity of the data. An incorrect interpretation can lead to incorrect decisions.
Bullish divergence is a situation in which an indicator reveals a likely bullish move but price trends downward. Other approaches to trading in such situations include:
- Using support and resistance levels: Identifying and trading off support and resistance levels can help traders better anticipate when a price reversal may happen.
- Utilizing chart patterns and trendlines: Traders can look for reversal chart patterns such as head and shoulders, double tops and bottoms, and wedge formations. Additionally, traders can use trendlines to help them spot potential reversals.
- Employing technical indicators: Other technical indicators such as moving averages, oscillators, and momentum indicators can also be used to identify potential price reversals.
- Monitoring news and events: Keeping an eye on news and events can also provide traders with an opportunity to get in or out of a trade before a price reversal occurs.
In summary, bullish divergence signals a potential price reversal, and a variety of approaches such as using support and resistance levels, chart patterns and trendlines, technical indicators, and monitoring news and events can be used to capitalize on the situation.
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- Ramlall I. (2016), Applied Technical Analysis for Advanced Learners and Practitioners, Emerald Group Publishing, UK
- Thomsett M. (2014), Getting Started in Stock Analysis, Illustrated Edition, John Wiley & Sons, Singapore
- Wiley (2019), Wiley Securities Industry Essentials Exam Review 2019, John Wiley & Sons, New Jersey
Author: Sylwia Szrajber