Bullish divergence

What Is Bullish Divergence?

Bullish divergence is a concept within technical analysis, a discipline within the broader field of financial markets and investing. It occurs when the price of an asset makes a lower low, but a corresponding technical indicator, such as a momentum indicator, forms a higher low. This disparity suggests that while sellers are still pushing prices down, the underlying selling pressure is weakening, often hinting at a potential trend reversal from bearish to bullish. Bullish divergence can be a crucial signal for traders and analysts, indicating a shift in market sentiment and potential upward price movement.³¹, ³²

History and Origin

The foundational principles of technical analysis, from which concepts like bullish divergence emerged, trace back centuries. Early forms appeared in 17th-century Dutch financial markets and 18th-century Japanese rice trading, with techniques like candlestick charting developing in Asia. However, modern technical analysis, as we know it today, is heavily influenced by the work of American journalist Charles Dow in the late 19th and early 20th centuries.³⁰

Dow, who co-founded The Wall Street Journal and created the Dow Jones Industrial Index, analyzed market data to identify patterns and cycles. His insights, later formalized into Dow Theory by William Hamilton and Robert Rhea, laid the groundwork for understanding market trends and included observations on how prices and market internals move.²⁹ While Dow himself did not explicitly define "bullish divergence," the concept is a natural extension of monitoring the relationship between price action and underlying market strength, a core tenet of technical analysis. The use of mathematical indicators to quantify market movements, which are essential for identifying divergences, gained prominence in the early 20th century with pioneers like Robert D. Edwards and John Magee.²⁸

Key Takeaways

• Bullish divergence occurs when an asset's price makes a lower low, but a momentum indicator shows a higher low, signaling a potential upward reversal.²⁶, ²⁷
• It suggests that selling pressure is diminishing, even as prices continue to decline.²⁵
• Common indicators used to identify bullish divergence include the Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), and Stochastic Oscillator.²³, ²⁴
• While a useful signal, bullish divergence should be confirmed with other technical tools and risk management strategies.²²
• It can be applied across various financial markets, including stocks, forex, and commodities.²⁰, ²¹

Formula and Calculation

Bullish divergence is not identified through a specific mathematical formula but rather through the visual comparison of price action and the corresponding movement of a technical indicator on a chart.

For example, when using the Relative Strength Index (RSI) to identify bullish divergence:

1. Identify Price Action: Observe if the asset's price is making a sequence of lower lows (L1, L2).
2. Observe Indicator Movement: Simultaneously, observe the chosen momentum indicator (e.g., RSI) for the same period. If the indicator forms a higher low (I1, I2) corresponding to the lower lows in price, bullish divergence is present.

Where:

• Price Low 1 and Price Low 2 represent consecutive lows in the asset's price.
• Indicator Low 1 and Indicator Low 2 represent the corresponding lows of the chosen momentum indicator.

The divergence itself is the discrepancy between these two movements. Other indicators like the MACD histogram or Stochastic Oscillator can also be used similarly to spot this type of divergence.¹⁹

Interpreting the Bullish Divergence

Interpreting bullish divergence involves understanding the underlying dynamics between price and momentum. When an asset's price continues to decline, setting lower lows, but a momentum indicator begins to rise, showing higher lows, it signals a potential shift in the market. This suggests that despite the price being pushed lower by sellers, the strength of the selling momentum is decreasing.¹⁸

This weakening selling pressure indicates that the market's internal dynamics may be changing, and buying interest might be quietly accumulating at lower levels. Traders often interpret this as a precursor to a potential upward price reversal. It's a signal that the bears might be losing control, and the bulls could be preparing to step in and drive prices higher. This divergence serves as an early warning that the prevailing downtrend might be losing steam, providing an opportunity for investors to anticipate a shift in direction before it becomes apparent in the price action itself.

Hypothetical Example

Consider a hypothetical example involving a technology stock, TechCo (TCO), currently in a downtrend.

1. Initial Price Drop: TechCo's price drops from $50 to $45, forming a low at $45. At this point, the Relative Strength Index (RSI) registers a value of 30, indicating oversold conditions.
2. Further Price Drop: The price continues to decline, reaching a new lower low of $40. However, instead of the RSI making a new low below 30, it registers a value of 35.
3. Bullish Divergence Identified: Here, the price has made a lower low ($40 vs. $45), but the RSI has made a higher low (35 vs. 30). This is a clear instance of bullish divergence.
4. Interpretation: This divergence suggests that while TechCo's price is still falling, the selling momentum, as measured by the RSI, is actually weakening. The reduced momentum implies that the sellers are becoming exhausted, and buying pressure may be building.
5. Potential Outcome: A trader observing this bullish divergence might anticipate a potential reversal in TechCo's price. They might look for additional confirmation, such as a break above a resistance level or a bullish chart pattern, before considering a long position. If confirmed, TechCo's price could subsequently rebound.

Practical Applications

Bullish divergence is a valuable tool in technical trading strategies across various financial instruments. It is particularly useful for identifying potential market bottoms or the end of a downtrend, allowing traders to position themselves for an upward move.¹⁷

In the equities market, for instance, a trader might observe a stock making new lows while its MACD histogram shows increasing strength (higher lows). This could prompt them to look for other confirming signals, like a breakout from a descending trendline, before entering a long trade. In the foreign exchange market, bullish divergence on a currency pair like EUR/USD might signal that the bearish trend is losing steam, potentially leading to a rebound.¹⁶ Similarly, in the cryptocurrency market, a trader could spot a bullish divergence on Bitcoin's price with its Stochastic Oscillator, suggesting that a price bounce is imminent after a significant correction.¹⁵

The Federal Reserve Bank of San Francisco, as part of the U.S. central bank, employs financial analysts who conduct extensive research across various economic and financial topics. While their work primarily focuses on broader economic trends, monetary policy, and financial stability, understanding market dynamics, including those identified through technical indicators, can indirectly contribute to their comprehensive market assessments and analysis of financial institutions.¹³, ¹⁴

Limitations and Criticisms

While bullish divergence can be a compelling signal for potential trend reversals, it is not without limitations and criticisms. One primary concern is that divergence signals are not always accurate and can sometimes provide false positives, meaning a divergence appears, but the expected reversal does not materialize.¹² This can lead to premature entries or missed opportunities if not properly managed.

Critics of technical analysis, in general, often point to the efficient market hypothesis (EMH). This theory posits that all available information is already reflected in asset prices, making it impossible to consistently "beat the market" using historical price data or technical indicators.¹¹ From this perspective, any patterns observed, including bullish divergence, are merely random occurrences in an efficient market.¹⁰

Furthermore, the effectiveness of divergence can vary significantly depending on the market conditions and the specific indicator used.⁸, ⁹ Some studies suggest that technical indicators, including those used to identify divergence, may perform better in certain market environments (e.g., trending markets) than in others (e.g., choppy or range-bound markets).⁷ Relying solely on bullish divergence without confirming it with other forms of market analysis, such as fundamental analysis or additional technical indicators, can lead to suboptimal trading decisions.⁶ Therefore, a balanced approach that acknowledges these limitations and incorporates comprehensive analysis is generally recommended.

Bullish Divergence vs. Bearish Divergence

The key distinction between bullish divergence and bearish divergence lies in the direction of the anticipated trend reversal and the relationship between price action and the momentum indicator.

While bullish divergence signals that a downward price movement is losing momentum, bearish divergence indicates that an upward price movement is losing steam. Both are valuable tools for traders seeking to anticipate market reversals, but they provide insights into opposite market conditions.⁵

FAQs

What technical indicators are best for identifying bullish divergence?

Commonly used momentum indicators for identifying bullish divergence include the Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), and Stochastic Oscillator. These indicators measure the speed and change of price movements, making them suitable for spotting discrepancies with price action.³, ⁴

Can bullish divergence be used on any timeframe?

Yes, bullish divergence can be identified and applied across various timeframes, from short-term intraday charts to long-term weekly or monthly charts. However, the significance and reliability of the signal may vary depending on the timeframe, with longer timeframes often providing more robust signals.

Does bullish divergence guarantee a price reversal?

No, bullish divergence does not guarantee a price reversal. It is a signal of potential weakening in the existing trend and building momentum in the opposite direction. Traders typically seek additional confirmation from other technical analysis tools, such as chart patterns, volume analysis, or support and resistance levels, before making trading decisions.²

Is hidden bullish divergence different from regular bullish divergence?

Yes, there is a distinction. Regular bullish divergence occurs when price makes a lower low, but the indicator makes a higher low, signaling a potential trend reversal. Hidden bullish divergence, on the other hand, occurs in an existing uptrend where the price makes a higher low, but the indicator makes a lower low. This suggests a continuation of the existing uptrend after a brief pullback.¹

Why is it called "divergence"?

It is called "divergence" because the price action and the technical indicator are moving in opposite, or diverging, directions. This contrast signals a disagreement between what the price is doing and what the underlying momentum or strength of that price movement indicates, hinting at a potential change.