Bearish divergence
Bearish divergence is the opposite of bullish divergence. It occurs when the price is rising while the momentum is declining. The pattern looks for higher high prices and lower low oscillator values. Bearish divergence happens when the market is preparing for a corrective decline. In the beginning of the bearish buildup, price fails to show any sign of corrective action as weak investors are buying from strong investors. When more strong investors exit the market and the distribution is finally over, the price will fail[1].
Bearish divergence occurs above the zero line on the positive side of the histogram. In an uptrend, prices make many new highs and the histogram confirms the trend by making new higher peaks above the zero line, mirroring the share price. Bearish divergence occurs when the market makes a new high and the histogram fails to reach a higher peak than its last. This contradiction indicates that a divergence is present, which suggests a weakening trend[2].
Direction of the trend
Bearish and bullish divergence are determined solely from the directional relationship between peaks and troughs, or slope, are the observed wave degree between the two data series, irrespective of the direction of the trend at the next higher wave degree.
Bearish (or negative) divergence implies that price will either:
- Reverse to the downside
- Continue declining to the downside
Bullish (or positive) divergence implies that price will either:
- Reverse to the upside
- Continue rising to the upside
With respect to reverse divergence, price is expected to continue in the direction of its current larger trend, moving in the opposite direction to that of the supporting data series. Unfortunately, there are two approachers in reverse divergence with contrary outcomes. In either case, if the supporting data series is moving to the upside, price is expected to move to the downside, and we say that we have reverse bearish divergence. Conversely, if the supporting data series is moving to the downside, price is expected to move to the upside, and we say that we have reverse bullish divergence[3].
Divergence between HPI and price aborts
Important divergences develop over the course of several weeks. A divergence that takes two months to develop is more powerful than the one in which two weeks passed between the tops or bottoms. Pay attention to the differences in the height of the adjacent tops or bottoms. If the first top or bottom is far away from the centerline and the second top or bottom is near that line, that divergence is likely to lead to a greater move.
Bearish and bullish divergences of HPI often have long lead times. Once you have identified a potential turning point using an HPI divergence, lean on short-term oscillators for more precise timing. If a divergence between HPI and price aborts, and you get stopped out, watch closely - you may get an even better trading opportunity if a regular divergences consist of three lower bottoms in prices and three higher bottoms in HPI. Triple bearish divergences consist of three higher tops in prices and three lower tops in HPI. They occur at some of the major turning points in the markets[4].
Examples of Bearish divergence
- The most common example of bearish divergence is when the price of an asset is making higher highs, but the oscillator is making lower highs. For example, if the stock market is making new highs, but the RSI (Relative Strength Index) is making lower highs, it could be indicative of a bearish divergence.
- Another example of bearish divergence occurs when the price is making higher lows, but the oscillator is making lower lows. This usually indicates that the underlying trend is weakening and that the trend could soon reverse.
- Bearish divergence can also be seen when the price is making lower highs while the oscillator is making higher highs. This is indicative of a weakening momentum, and that the trend could soon be ready to reverse.
- Finally, bearish divergence can also be seen when the price is making lower lows, but the oscillator is making higher lows. This is typically a sign that the momentum is weakening and the trend could be ready to reverse.
Advantages of Bearish divergence
The advantages of bearish divergence are:
- It provides a sign that the current trend may be losing strength and a reversal to the downside is possible.
- It gives a warning signal that the current price move is unsustainable and that the market may be overextended.
- It enables investors to identify potential buying opportunities when the market is oversold and prepare to exit the market when the trend starts to reverse.
- It allows investors to be proactive about their investments and make informed decisions about when to enter or exit a position.
- It helps to identify good entry points for short positions.
- It helps to reduce the risk associated with taking long positions in a bearish market.
Limitations of Bearish divergence
- Bearish divergence does not guarantee a bearish move, as it is a lagging indicator and may not always predict future price action correctly.
- The false signals that are generated by bearish divergence can cause traders to take wrong positions and incur losses.
- Bearish divergence is not a reliable indicator when the market is in a strong uptrend or a strong downtrend.
- If the oscillator is not well tuned, it could lead to unreliable bearish divergence signals.
To further analyze bearish divergence, there are a variety of other approaches that can be taken into consideration. These include:
- Using Moving Average (MA) crossovers to detect bearish divergence. In this approach, when the price is making higher highs and the MA is making lower lows, the signal is bearish divergence.
- Using Relative Strength Index (RSI) to signal bearish divergence. When the price is making higher highs and the RSI is making lower lows, it signals bearish divergence.
- Using the MACD indicator to signal bearish divergence. When the MACD line is below the signal line and the price is making higher highs, it is a signal of bearish divergence.
In conclusion, bearish divergence can be identified and analyzed using a variety of approaches, such as moving average crossovers, relative strength index, and the MACD indicator. By utilizing these approaches, investors can better identify and analyze bearish divergence in order to make more informed decisions.
Footnotes
| Bearish divergence — recommended articles |
| Bull flag — Bullish divergence — Uptrend — Dragonfly Doji — Three Black Crows — Inverted hammer — Bear flag — Symmetrical triangle — Chande Momentum Oscillator |
References
- Elder A. (1993), Trading for a Living: Psychology, Trading Tactics, Money Management, John Wiley & Sons, New York.
- Lee R.M, Tryde P. (2012), Timing Solutions for Swing Traders, John Wiley & Sons, Hoboken.
- Lim M.A. (2015), The Handbook of Technical Analysis, John Wiley & Sons, Milton.
- Pollard J. (2011), Smart Trading Plans, John Wiley & Sons, Milton.
Author: Michał Duch
