>DIFFERENT TYPES OF DIVERGENCES

Divergence, which is a term that technicians use when two or more averages or indices fail to show confirming trends, is one of the mainstays of technical analysis. Here’s a new way to use oscillators and divergence as well as methods to locate entry levels during a trend.

Most technical indicators mirror or confirm price movement. When price moves up, the indicator moves up; when price moves down, the indicator moves down. When prices peak, the indicator
peaks; and when prices bottom, the indicator bottoms. Sometimes, however, a discrepancy occurs between price and indicator movement. That discrepancy is known as nonconfirmation and can be seen most clearly on overbought or oversold indicators as well as on indicators that move above or below a zero line. Many traders only learn to recognize the type of nonconfirmation that occurs at market tops and bottoms, which is the classic divergence. But there are other forms of nonconfirmation I call hidden divergence (HD) that, when present, offer additional profit potential.

Hidden Divergence
Hidden divergences are the opposite of classic divergences. Classic divergence looks for lower low prices accompanied by higher indicator values at price bottoms and higher high prices accompanied by lower indicator values at price tops. Hidden divergences, on the other hand, seek higher price lows accompanied by lower indicator values during up moves and lower price highs accompanied by higher indicator values during down moves. Most hidden divergences signal continuation moves in the direction of the prevailing trend.

CLASSIC DIVERGENCE
Classic divergence is one of the best-known types of nonconfirmation. A divergence is a separation between price and indicator that warns of a possible short- to intermediateterm change of trend. A bullish divergence arises during a down move when price makes either a lower low or a double bottom but the indicator makes a higher low or a double bottom. A bearish divergence occurs during an up move when price makes either a higher high or a double top and the indicator makes a lower high or a double top. Classic divergences can occur at price tops or bottoms and also at price corrections.

THE BULLISH HIDDEN DIVERGENCE
In a bullish HD, the indicator makes a lower low, but price makes either a higher low or a double-bottom low. This type of nonconfirmation occurs mainly during corrective declines in an uptrend, but it may also be found on occasion at price retests of the lows. Bullish HDs indicate underlying strength in the security and often make good entry or re-entry points. During its spectacular rise (and before its equally spectacular decline), Micron Technology [MU] displayed many bullish
hidden divergences (Figure 2) in 1995. At point 2, the indicator made a lower low than it had at point 1, but price made a higher low at point 2 than it had at point 1. In May, at point 4, the indicator was lower than at point 3, but the price low at point 4 made a double bottom with the price low at point 3 before price resumed its advance. As the indicator made lower lows in July and August at points 6 and 7 than it had at point 5, price continued to make higher lows. Another double-bottom price low occurred at points 8 and 9, but the indicator made a lower low at point 9, signaling the potential for additional strength.

THE BEARISH HIDDEN DIVERGENCE
In a bearish HD, price makes a lower high, but the indicator makes a higher high. This type of nonconfirmation is mainly found during corrective rallies in a downtrend but may also occur during retests of a price top. Bearish HDs signal potential underlying weakness in a security.

To read the full report: TYPES OF DIVERGENCES