If you trade in the forex market and already use technical analysis techniques in your trading plan, then you may already be familiar with regular and hidden divergence and their importance in signaling profitable trades. Many technical traders may already watch for the regular divergence that occurs when an indicator fails to make new extremes along with the exchange rate.
Hidden divergence may not be as easy to spot as regular divergence, but it can be an invaluable tool for forex trend traders since the appearance of hidden divergence typically signals a continuation of a prevailing trend is likely. By learning to recognize hidden divergence, forex traders can act on its signals and turn them into profitable trades.
In this article, Benzinga explains hidden divergence and how it differs from regular divergence, as well as how forex traders can profit from using this important technical signal.
What Is Divergence?
Divergence occurs when a momentum oscillator “diverges” or acts differently from the exchange rate with respect to the peaks or troughs seen on its chart. The two common types of divergence that can often be seen when comparing an exchange rate chart with a momentum oscillator are:
- Regular/classic divergence: Regular or classic divergence occurs when an exchange rate makes higher highs during an uptrend or lower lows during a downtrend but the indicator instead respectively makes lower highs or higher lows at those same time points. When you see this visual discrepancy that identifies regular or classic divergence appearing on an exchange rate chart, it can signal a loss of momentum in the market that can result in a trend reversal.
- Hidden divergence: Hidden divergence occurs when a momentum oscillator makes a series of higher highs or lower lows but the exchange rate instead makes lower highs or higher lows at the same time. Hidden divergence tends to be less apparent than regular divergence on an exchange rate chart, and it typically signals that momentum remains strong, so a continuation of the prevailing trend is likely.
Regular and hidden divergences are usually classified as bullish or bearish when they appear depending on their implication for the future direction of the market.
For example, the appearance of regular bullish divergence would suggest the market will reverse a recent decline and move higher, while an exchange rate chart showing bearish hidden divergence would suggest that the market will continue its recent decline.
What Is Hidden Divergence?
Like regular divergence, hidden divergence occurs when an exchange rate and an indicator move in opposite directions. In contrast to regular divergence signaling a market reversal, hidden divergence tends to signal the continuation of a trend. Hidden divergence also often occurs during consolidation or correction phases in the market.
Seeing hidden divergence show up on an exchange rate chart indicates to a savvy technical trader that the exchange rate should continue to move in the direction of the prevailing trend. They can use this signal to increase their trend-following position size.
Bullish Hidden Divergence
Hidden bullish divergence occurs when an exchange rate currently progressing in an overall upwards trend shows a succession of higher lows on its chart while simultaneously showing a series of lower lows on the graph of a momentum oscillator.
When a momentum indicator fails to make higher lows in an uptrend, this hidden bullish divergence is usually taken as confirmation that a continuation of the previous uptrend is more likely than not.
Bullish hidden divergence often occurs during periods of consolidation during an upwards trend. Its appearance can signal that the uptrend has not been exhausted and that the exchange rate will continue to move higher.
Bullish hidden divergence can also arise when most of the selling seen in the forex pair has been as a result of profit-taking by short-term players and does not instead arise from the large and long-held transactions that tend to determine an exchange rate’s overall trend.
Bearish Hidden Divergence
Hidden bearish divergence occurs when an exchange rate that is currently in an overall downtrend shows a series of lower highs on its chart where the corresponding graph of a momentum oscillator shows a succession of higher highs.
When the momentum oscillator fails to make lower highs in an overall downtrend, this hidden bearish divergence tends to confirm that a continuation of the previous downtrend is likely.
Bearish hidden divergence is a continuation signal that typically occurs during a period of consolidation or reaction during a downtrend. It indicates that selling interest in the currency pair has yet to be exhausted.
The short-term buying that takes the exchange rate temporarily higher when hidden bearish divergences are seen also probably arises from short-sellers taking profits, instead of from large transactions to purchase the forex pair and hold it for the long term.
Trading Hidden Divergence in Forex
Forex technical analysts commonly use momentum oscillators like the Moving Average Convergence Divergence (MACD) indicator, the Stochastic Oscillator and the Relative Strength Index (RSI) to detect hidden bullish and bearish divergence in exchange rates.
The first thing you will need to do when looking for hidden divergences in a forex currency pair’s exchange rate is to determine the direction of the prevailing overall trend. This can be done by plotting a 200-period exponential moving average (EMA) over the exchange rate chart for a currency pair.
If the exchange rate for a currency pair trades above its 200-period EMA, then the long-term trend is higher. This means a trend trader would only take long positions in that pair so that they continue to trade along with the trend. Conversely, if the pair’s exchange rate trades below its 200-period EMA, then a trend trader would only take short positions in that currency pair.
Once you’ve determined the prevailing overall trend, you can then select the momentum oscillator that you feel most comfortable using to find hidden divergences. You can now watch for hidden divergence between the indicator and the exchange rate as it arises to signal that the market will continue to move in the direction of the prevailing trend.
When using this hidden divergence trading strategy, keep in mind that you would only want to establish trading positions when a signal arises and then only in the direction of the prevailing overall trend as determined by the 200-period EMA.
Should You Use Hidden Divergence in Your Forex Trading?
Divergence and hidden divergence are some of the most reliable leading indicators for signaling a market reversal and continuation. Combined with other signal-generation strategies, the use of divergence and hidden divergence can significantly improve your forex trading results.
If your trading strategy involves identifying and positioning for trends or corrections, then it would usually make sense to train yourself to watch for hidden divergence and other divergence pattern types that can show up on the technical indicators you feel most comfortable using.
When it comes to signaling profitable trades, hidden divergence is a higher probability divergence pattern when used in its typical role as a trend continuation indicator than classic divergence when used to signal trend reversals. This makes hidden divergence an important signaling tool for technical forex traders.
Keep in mind that using longer time frames tends to produce more reliable hidden divergence signals. For example, when hidden divergence appears on a four-hour chart, then that would be a more solid indicator to follow than if it showed up on a 15-minute chart instead.
Frequently Asked Questions
Is hidden divergence effective?
When properly interpreted, hidden divergence has proved to be a reliable leading indicator of future exchange rate movements. Since hidden divergence generally occurs during a consolidation period after a directional movement, it can signal when to optimally establish positions to profit from a resumption of the underlying trend.
Which is better regular or hidden divergence?
When it comes to signaling profitable trades, hidden divergence is often considered a higher probability divergence pattern when used in its typical role as a trend continuation indicator than regular divergence that is used to signal trend reversals. Using a combination of regular and hidden divergence can give you better overall results.
What does hidden divergence indicate?
Hidden divergence generally indicates that a continuation of an underlying trend is likely. During consolidation periods, the appearance of hidden divergence can signal that a continuation of the prevailing trend may be forthcoming regardless of whether the overall trend is bullish or bearish.