What is hidden bullish divergence?
Divergence is one of the most common ways to trade the financial markets. Divergence, as the name suggests forms when the oscillator and the price action fail to converge.
In other words, under normal conditions price action and the oscillator tend to move in the same direction. When price makes a new high, the oscillator is also prone to make a new high. Likewise, when price makes a new low, the oscillator is also prone to make a new low.
When this convergence fails, what you basically get is divergence.
Divergence is known to be a leading indicator of price action. In other words, when you see a divergence, there is a high likelihood that price action will potentially make a reversal.
There are many different types of divergences available. The divergences are categorized into regular and hidden divergences.
While the regular divergence is easy to spot, hidden divergences are less rare and requires some practice to spot them.
Within the hidden divergence, you have the bullish and the bearish divergence.
How does the hidden bullish divergence work?
A hidden bullish divergence works based on the concept of the lows in price and the lows in the oscillator.
For divergence to work, you basically need an oscillator. Any type of oscillator works in this case. However, the most commonly used oscillators are the relative strength index (RSI), the Stochastics oscillator and the MACD. Other examples of oscillators that can signal divergence is the awesome oscillator.
The first chart below shows a basic design of how the hidden bullish divergence looks like. Traders should note that this textbook pattern hidden bullish divergence does not always work the same way. Therefore, some amount of flexibility should be allowed.
Figure 1: Hidden bullish divergence
In figure 1, you have the basic illustration of the hidden bullish divergence. In this illustration, you can see that price makes a higher low compared to the initial low. However, the oscillator makes a lower low relative to the previous low.
This set up basically signals a hidden bullish divergence.
Following the formation of the hidden bullish divergence, price tends to break out higher.
The next chart example shows the hidden bullish divergence using the relative strength index indicator.
In figure 2, we have a real time example of the hidden bullish divergence. As you can see, comparing the lows in the price and the lows in the oscillator, the hidden bullish divergence is formed.
After the formation of the higher low in price, price then surges to form a peak.
It should be noted that the hidden bullish divergence can form anywhere in a trend. Typically though, the hidden bullish divergence can be formed in an uptrend. It forms close to the highs in the price action.
There are many ways to trade the hidden bullish divergence.
How to trade the hidden bullish divergence?
The hidden bullish divergence method can be used in a number of ways. Due to the fact that the hidden bullish divergence is a leading indicator, it can potentially tell you what could happen in price. Generally speaking, when a hidden bullish divergence is formed, you can take long positions.
However, not all hidden bullish divergences are successful. You can find many examples of a failed hidden bullish divergence.
The most ideal place where a hidden bullish divergence can occur is at the end of a downtrend. Near the bottom end of the downtrend, a hidden bullish divergence can be a powerful trading signal.
This is illustrated in the next chart below.
In figure 3, we have the hidden bullish divergence that is formed near the bottom end of the downtrend. If you closely observe, what you first see is a minor correction in price. This leads to a higher low in price. At the same time, the relative strength index indicator forms a lower low.
This divergence then leads to an uptrend. One of the ways to trade the hidden bullish divergence is shown below.
The entry of the trade is placed near the interim peak of the hidden bullish divergence. The stops are placed at the higher low in price. Following this, a 1:1 and 1:2 risk reward set up positions are taken.
As you can see in the above chart, price action eventually closes out near the 1:2 target price level.
A hidden bullish divergence can fail when price fails to break the interim high.
The next chart above shows a failed hidden bullish divergence. Here, although price action jumped higher after posting the higher low, prices failed to maintain the gains.
Following the interim high that is formed, price action barely tests this high and then drops off. This leads to a downside correction in prices. The decline leads to a strong downside reversal in prices.
As you can see while this looks like a failed hidden bullish divergence, you can see that the failure of the interim high leads to prices posting a reversal to the downside.
Another point to note is that when the hidden bullish divergence forms nears the top end of the rally, you can expect to see a topping pattern being formed. On the other hand, when a hidden bullish divergence forms, you can expect to see a reversal on the lower side.
Hidden bullish divergence trading – Conclusion
In conclusion, the hidden bullish divergence trading is one of the simplest ways to trade. You can incorporate this trading strategy into any existing trading system. In the above sections, we make use of the relative strength index to illustrate the hidden bullish divergence in its simplest form.
You can of course, make use of any other favorite technical oscillator of your choice.
The hidden bullish divergence does not occur that often and are a bit rare compared to other forms of divergence set ups. However, when you see the hidden bullish divergence pattern, you can potentially prepare yourself in anticipation of what price action will do in the near term.