Bullish Divergences and Bearish Reversal Signals

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Bullish Divergences and Bearish Reversal Signals

Bullish divergences are essentially the inverse of bearish signals. Trading oscillators, despite their simplicity of use and overall informative strength, are sometimes misunderstood in the trading sector, despite their tight association with momentum. At its most basic, momentum is a method of gauging the relative degrees of greed or fear in the market at any particular time.

Key Takeaways

  • Divergences are used by technical traders to read momentum, such as when the market’s momentum is about to change direction or the speed at which an investor is approaching a possible momentum shift.
  • Oscillators are helpful tools for investors to use, particularly when their readings are in opposition to prices; for example, a bullish divergence emerges when a price hits a new low but an oscillator fails to follow suit.
  • Oscillators are effective for detecting short-term market shifts, as opposed to trend-following indicators, which are more useful for detecting long-term trends.

Divergence Oscillators

When oscillators’ readings deviate from prices, they are most valuable and provide the most reliable trading signals. A bullish divergence happens when prices fall to a new low but the oscillator does not. This condition shows that bears are losing strength and that bulls are preparing to retake control of the market—often, a bullish divergence signals the conclusion of a slump.

When prices surge to a new high but the oscillator refuses to reach a new high, this indicates a probable decline. In this position, bulls are losing control of the market, prices are increasing solely due to inertia, and bears are poised to retake control.

Classes of Divergences

Divergences have been categorised according to their strength, whether bullish or bearish in nature. Class A divergences are the most powerful; Class B divergences are less powerful; and Class C divergences are the weakest. Class A divergences suggest the finest trading chances, whilst Class B and C divergences show turbulent market activity and should be disregarded.

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Class A negative divergences occur when prices reach a new high but the oscillator only reaches a high that is lower than the preceding rally’s high. Class A bearish divergences often indicate a quick and major reversal into a downtrend. Class A positive divergences occur when prices make a new low but the oscillator makes a higher low than it did during the prior downturn. Class A bullish divergences are often the greatest predictors of a rapid rise.

Prices forming a double top with an oscillator tracking a lower second top are examples of Class B bearish divergences. When prices trace a double bottom and an oscillator traces a higher second bottom, a Class B bullish divergence occurs.

When prices climb to a new high, but an indicator pauses at the same level it reached during the previous rally, this is referred to as a Class C bearish divergence. When prices fall to a new low while the indicator tracks a double bottom, a Class C bullish divergence occurs. Class C divergences are most symptomatic of market stasis, since bulls and bears are not growing stronger or weaker.

The Effect of Momentum and Rate of Change

Divergences provide traders with a rather exact point at which the market’s momentum is likely to shift direction. Aside from the exact instant, you must also determine the speed with which you are approaching a possible change in momentum. Market trends may accelerate, decelerate, or remain constant. The rate of change is a leading indication that may be used to determine this pace (RoC).RoC compares today’s closing price to a closing price determined by the trader X days ago:

RoC = Today’sClosingPrice ClosingPrice x DaysAgo \begin{aligned} &\text{RoC} = \frac { \text{Today’s Closing Price} }{ \text{Closing Price } x \text{ Days Ago} } \\ \end{aligned} ​​

A similar technique is used to compute momentum, which is an essential mathematical way of determining the rate of change in the market. Momentum, on the other hand, subtracts the previous day’s closing price from today’s:

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M = Today’sClosingPrice ClosingPrice x DaysAgo where: M = Momentum \begin{aligned} &\text{M} = \text{Today’s Closing Price} – \text{Closing Price } x \text{ Days Ago} \\ &\textbf{where:}\\ &\text{M} = \text{Momentum} \\ \end{aligned} ​​

Momentum is positive if the price today is higher than the price X days ago, negative if the price today is lower, and zero if the price today is the same. Using the estimated momentum figure, the trader will then draw a slope for the line linking the calculated momentum values for each day, indicating whether momentum is growing or declining in a linear way.

Similarly, the rate of change is calculated by dividing the most recent price by the closing price X days ago. RoC is 1 if both values are equal. If the current price is higher, the RoC is more than one. And, if the price is lower today, the RoC is less than one. The slope of the line connecting the daily RoC data visually depicts whether the rate of change is increasing or decreasing.

How to Use Momentum as a Trader

A trader must choose the time frame to employ when computing momentum or RoC. As with nearly every oscillator, keeping the window small is often a good rule of thumb. Oscillators are best for identifying short-term market movements, such as those that occur within a week, but trend-following indicators are better for detecting longer-term trends.

When momentum or RoC reaches a new high, the market’s optimism grows, and prices are expected to climb. When momentum or RoC reaches a new low, the market’s pessimism rises, and lower prices are anticipated.

When prices climb but momentum or RoC declines, a peak is likely to be on the horizon. When locking in profits from long positions or tightening your protective stops, this is a crucial indicator to watch for. A bearish divergence has occurred, which is a strong sell signal, if prices achieve a new high but momentum or RoC reach a lower top. The resulting bullish divergence is a clear purchase signal.

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The Bottom Line

Divergent oscillators are powerful leading indicators that guide the trader on not only the market’s future direction but also its speed. When combined with demonstrable divergences, momentum and RoC can precisely ascertain near the moment a market shifts direction.

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