By Vito Henjoto, Technical Analyst, GFT

Continuing the divergence series from last week, we will be looking at the three most commonly used indicators to identify divergences in the market, in order of divergence frequency:

-    Relative Strength Index (RSI)
-    Stochastics
-    MACD

We will also look at how different oscillators show divergences.

RSI

Amongst the three types mentioned above, RSI is unique as it doesn’t oscillate in the same way as seen in both MACD and Stochastics.

RSI is viewed in the same way as price is viewed. Because of this, RSI provides the fastest and most frequent divergence signal among the three. Unfortunately, there's no such thing as total perfection, and there are still issues with RSI, as divergences are merely a sign of things to come. Without other solid reasons that explain not only the existence of the divergence, but the reason it occurred in the first place, these signals evaporate and provide traders with either misleading or false signals.

RSI treated as a divergence is best suited for longer time frames; as such, if you classify yourself as a swing trader or a position trader, you're likely to benefit more from RSI divergence. 

I have included an example of RSI divergence taken in the week beginning 18th February 2013 to illustrate this.

Figure 1 RSI Divergences

The Rest - Stochastics and MACD

Stochastics and MACD are the more traditional divergence identification.  The only difference between the two is that MACD provides less divergence identification than found with Stochastics. This is a double edged sword, as it's likely to filter out a potential false divergence whereas at the same time the lack of divergences identified could cause traders to miss out on a potential trade.

Below are two charts showing the same period of time and the amount of divergences identified by a slow stochastic and MACD in GOLD prices.

Figure 2, MACD Divergences

Figure 3, Slow Stochastics Divergences

Hidden Divergences

With a better understanding on how to identify these divergences, let's discuss hidden divergences.  Now, there's plenty of confusion surrounding hidden divergences, partly because the way a trader will identify a hidden divergence is at odds with the way a normal “regular” divergence is identified.

Hidden divergences only occur when a trend has been established in the market. It is a continuation pattern and works well with continuation chart patterns, such as descending/ascending triangles, flags and wedges to name a few. A hidden divergence occurs when momentum keeps building up during consolidation to the point where it is overstretched and the snap back effect takes the market out of the consolidation range. 

Now, let’s turn to the different kinds of hidden divergence and some of their characteristics:

Hidden Bullish Divergence

-    Occurs only in an uptrend
-    Price creates a higher low (up-trend)
-    Oscillator creates a lower low (allowing more momentum to be released)

Hidden Bearish Divergence

-    Occurs only in a downtrend
-    Price creates a lower high (down-trend)
-    Oscillator creates a higher high

The most effective way to demonstrate the different forms of hidden divergences is through visual representations -  so I've included some charts taken from the week commencing 18th February 2013 to illustrate the effectiveness of being able to recognise hidden divergences.

GBP/USD

In the chart above, GBP/USD is quickly losing momentum towards the end of the chart.  Without knowledge of hidden divergence, most traders will identify the lack of downward pressure as a potential reversal in the market. However, the pair did form a hidden divergence by demonstrating a lower high on price and at the same time slow stochastic is showing a higher high. Here is what follows next:

When price breaks below the support trendline of the channel, it triggers a massive drop to the downside. These examples are very recent, taken between 19th February 2013 and 20th February 2013.

Here are more examples of the effectiveness of hidden divergences:

AUS200

EUR/USD

Concluding Divergence

Over the past two weeks, we've covered all kinds of divergence - both regular and hidden - and discussed the causes, signs of divergence and how important it is to differentiate between them.  Next week, we'll discuss RSI vs Stochastics.

As always, if you have any questions for me, simply ask me via the Ask the Expert panel here.

Click on the links below to read other articles from this week's newsletter

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18 Share Tips - 25 February 2013

Rising sharemarket will unleash IPOs

Explainer: what are safe haven investments?

Great Company Or Growing Industry?

How To Outperform The Market       

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Stock on the slide: ASX rolling 52-week lows