Definition of divergence indicator

Divergence is a very popular term in technical analysis. It indicates possible reversal signals when there are discrepancies between an indicator and price movement.

The divergence occurs when price and indicator move in different direction.
For instance, price is moving in an uptrend and reaches a higher high than previous swing high (peak), but at the same time the indicator is trending downward. 


Divergence involves two parts, price and indicator.

Price is the price value on the main chart.

Indicator, in most case, it should be a sub chart indicator with line plot, such as RSI, CCI, ADX, etc. We can also use histogram style indicator to detect divergence, such as MACD or Volume related indicators.

Please note that we check the price first, if the price action met the rule of divergence then we check the indicator's value, not the other way around.

For example, we do not define the chart below as divergence, since bar A is not a swing high.  Definition of swing point (https://patternsmart.blogspot.com/2018/08/what-is-swing-point-swing-high-and.html)


 


There are three commonly known types of divergence: regular, hidden and exaggerated.

Exaggerated divergence is a special type of divergence.
It is when two of the most recent tops or bottoms on price are equal, but the indicator is in the different direction of the price movement.

For all of our divergence indicators, we treat exaggerated divergence as a regular type.

Regular bearish divergence

It's when price is in uptrend and makes a higher high than the previous swing high (peak), but the indicator value of the new high is lower than the indicator value of the previous peak. 

The chart below is an example of regular bearish divergence.

Regular bullish divergence

It's when price is in downtrend and makes a lower low than the previous swing low (trough), but the indicator value of the new low is higher than the indicator value of the previous trough. 

The chart below is an example of regular bullish divergence.

Hidden bearish divergence

It's when price is in a downtrend and makes a lower high than previous swing high (peak), but the indicator value of the new high is higher than the indicator value of the previous peak. 

The chart below is an example of hidden bearish divergence.

Hidden bullish divergence

It's when price is in uptrend and makes a higher low of the previous swing low (trough), but the indicator value of the new low is lower than the indicator value of the previous trough. 

The chart below is an example of hidden bullish divergence.







Please note that divergence is not always followed by a trend reversal. 
Sometimes the trend will continue even after a divergence occurred.





Everyone has different understanding of divergence, in our definition, the following conditions will not be considered as divergence.



Example 1, as shown in the chart below.

If you used bar B's Close as the start point of a divergence, there will be a problem.
Since bar B's Close is not a swing high (peak), bar A's High is a swing high (peak). 

Definition of swing point (https://patternsmart.blogspot.com/2018/08/what-is-swing-point-swing-high-and.html)










My algorithm only defines divergence based on swing high/low as start point. Because if using any price (open, close, high, low) as start point there will be too many false divergence (lines) on chart.  For example, if you consider B as the start point, the 2 bars before B should also be start point, since these 3 bars have the same condition.