Bearish Divergence – Introduction
The bearish divergence is one of the most popular tools that traders utilize to time market reversals.
A divergence in a market is an early signal that an existing trend is likely to reverse and/or consolidate.
In this article, we will focus on spotting bearish divergences. As well as, providing some tips and tricks to trade them profitably.
What is a Bearish Divergence?
This type of divergence forms on your chart when price prints a higher high, but the indicator you are using fails to follow suit.
In Lehman’s terms, when price action makes a new high, the indicator should confirm this by also making a new high.
If the indicator prints a lower high while price trades higher, this is a sign of a potential shift in momentum.
We are often taught as traders to trade what you see, so when price actions falls out of sync with your indicator, attention is required!
The below image is an example of a typical bearish divergence setup.
How to Spot Bearish Divergence?
Divergences are quite easy to spot with the right tools.
The most popular types of indicators used to identify divergences include the MACD, the RSI (Relative Strength Index) and/or the Stochastics.
If you want to learn more about MACD Divergence Trading, click here to read the article.
Be sure to note that it doesn’t actually matter which indicator you end up using in your analysis.
As you can see on the 4H chart of the NZDJPY below. Even though the indicators are all calculated differently, they tend to produce the same signals.
Trade Bearish Divergences Like a Pro
It is important to understand that a divergence in itself is not enough of a reason to qualify a trade.
While the psychology behind the pattern indicates a shift in momentum, additional filters should be applied in order to prevent trading false signals.
The below case study is a perfect example of a high probability bearish divergence setup. Let’s walk through the process behind identifying and executing on this pattern.
Step by Step Breakdown
The best bearish divergence setups occur when a market is in an overall bearish trend but currently within a counter-trend pullback. We prefer to lean on the daily timeframe to identify trend and key levels, while utilizing the 4H chart to locate entries.
(1) In this example, the NZDUSD pair is in an overall downtrend. The market has found support near the $0.64200 level and is in the process of a buy stop run to flush out the late shorts. We consider this price action to be a pullback to value within the trend. We are looking to qualify a short trade on a signal that the counter-trend momentum has fizzled out.
Pro Tip: One of the important qualifiers we use to trade divergence setups is that the market must have made an overextended run on the lower time frame before the signal.
(2) The market trades up into the $0.66000 round number resistance and prints a short-term high. The pair then pulls back from this high into the $0.64500 level and finds support. At this point, there is still no valid setup. We do, however, have 2 conditions we require to see: (1) An overextended run (2) Price forms resistance at key level ($0.66000 key level).
(3) The market pushes off the lows at $0.64500 and creates a new higher high above $0.66000. If this breakout is for real, the RSI indicator should confirm price action with a higher high.
Pro Tip: A failed breakout above previous resistance enhances the odds of this setup. This is because retail traders get stuck buying the high after an extended run. When the market rotates back below structure, these trapped traders puke their positions, accelerating the downside move.
(4) The RSI indicator prints a lower high, while price action has just printed a higher high. This is our signal that the momentum of the counter-trend rally has fizzled out. We can now qualify a short trade in this market as our setup requirements have been fulfilled. <(a) Overextended counter-trend run? Check (b) Price at key resistance level? Check (c) Trapped Traders? Check (d) Bearish Divergence? Check >
(5) The market sells off over 100 pips after the bearish divergence setup is validated.
Conclusion
The bearish divergence is a very powerful trading concept in the hands of a skilled trader.
When utilized in the right market context, traders can develop an effective method to find low risk shorting opportunities.
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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.
