Bullish divergences are, in essence, the opposite of bearish signals. Despite their ease of use and general informational power, trading oscillators tend to be somewhat misunderstood in the trading industry, even considering their close relationship with momentum. At its most fundamental level, momentum is actually a means of assessing the relative levels of greed or fear in the market at a given point in time.
Oscillators are most useful and issue their most valid trading signals when their readings diverge from prices. A bullish divergence occurs when prices fall to a new low while an oscillator fails to reach a new low. This situation demonstrates that bears are losing power, and that bulls are ready to control the market again—often a bullish divergence marks the end of a downtrend.
Bearish divergences signify potential downtrends when prices rally to a new high while the oscillator refuses to reach a new peak. In this situation, bulls are losing their grip on the market, prices are rising only as a result of inertia, and the bears are ready to take control again.
Classes of Divergences
Divergences, whether bullish or bearish in nature, have been classified according to their levels of strength. The strongest divergences are Class A divergences; exhibiting less strength are Class B divergences; and the weakest divergences are Class C. The best trading opportunities are indicated by Class A divergences, while Class B and C divergences represent choppy market action and should generally be ignored.
Class A bearish divergences occur when prices rise to a new high but the oscillator can only muster a high that is lower than exhibited on a previous rally. Class A bearish divergences often signal a sharp and significant reversal toward a downtrend. Class A bullish divergences occur when prices reach a new low but an oscillator reaches a higher bottom than it reached during its previous decline. Class A bullish divergences are often the best signals of an impending sharp rally.
Class B bearish divergences are illustrated by prices making a double top, with an oscillator tracing a lower second top. Class B bullish divergences occur when prices trace a double bottom, with an oscillator tracing a higher second bottom.
Class C bearish divergences occur when prices rise to a new high but an indicator stops at the very same level it reached during the previous rally. Class C bullish divergences occur when prices fall to a new low while the indicator traces a double bottom. Class C divergences are most indicative of market stagnation—bulls and bears are becoming neither stronger nor weaker.
The Effect of Momentum and Rate of Change
With divergences, traders identify a rather precise point at which the market's momentum is expected to change direction. But aside from that precise moment, you must also ascertain the speed at which you are approaching a potential shift in momentum. Market trends can speed up, slow down or maintain a steady rate of progress. A leading indicator that you can use to ascertain this speed is referred to as rate of change (RoC). RoC compares today's closing price to a closing price X days ago, as chosen by the trader:
RoC = Today's Closing Price / Closing price X days ago
A similar formula is used to calculate momentum, itself an important mathematical means of ascertaining the speed of the market's change. Momentum, however, subtracts the previous day's closing price from that of today:
Momentum = Today's closing price—Closing price X days ago
Momentum is positive if today's price is higher than the price of X days ago, negative if today's price is lower and at zero if today's price is the same. Using the momentum figure calculated, the trader will then plot a slope for the line connecting calculated momentum values for each day, thereby illustrating in linear fashion whether momentum is rising or falling.
Similarly, the rate of change divides the latest price by a closing price X days hence. If both values are equal, RoC is 1. If today's price is higher, then RoC is greater than 1. And, if today's price is lower, then RoC is less than 1. The slope of the line that connects the daily RoC values graphically illustrates whether the rate of change is rising or falling.
How to Use Momentum as a Trader
Whether calculating momentum or RoC, a trader must choose the time window that he or she wishes to use. As with most every oscillator, it is generally a good rule of thumb to keep the window narrow. Oscillators are most useful in detecting short-term changes in the markets, perhaps within a time frame of a week; while trend-following indicators are better employed for longer-term trends.
When momentum or RoC rises to a new peak, the optimism of the market is growing, and prices are likely to rally higher. When momentum or RoC falls to a new low, the pessimism of the market is increasing, and lower prices are likely coming.
When prices rise but momentum or RoC falls, a top is likely near. This is an important signal to look for when locking in your profits from long positions or tightening your protective stops. If prices hit a new high but momentum or RoC reaches a lower top, a bearish divergence has occurred, which is a strong sell signal. The corresponding bullish divergence is an obvious buy signal.
The Bottom Line
Divergent oscillators are powerful leading indicators that guide the trader on not only the market's future direction but also its speed. When combined with demonstrable divergences, momentum and RoC can precisely ascertain near the moment a market shifts direction.