Divergences can be an important warning signal that a bullish trend is ending. In the last article I talked about how to use bullish divergences to time an entry into a new long position or to look out for weakness in a downward trend but there are also bearish divergences that long traders need to watch for.
Besides describing a bearish divergence I will further refine divergence analysis, in this article, to help you understand what types of divergences matter most and what you should be looking for on a day to day basis.
Trading divergences - Part Two
To see the first article in this series, click here. To see the third article in this series, click here.
A bearish divergence occurs when prices continue to form higher highs (typical in a bull market) while your oscillator (in this case an RSI) is forming significantly lower highs (indicating weakness in the trend.)
We have further defined this signal as a period of diverging trends between prices and the indicator when the indicator has been making peaks in the "overbought" territory.
If you are using the RSI to look for divergences that means that you will pay the most attention to divergences when the indicator's peaks are above 70 or "overbought." You can see exactly this sort of formation and the resulting down trend on the chart below of Ebay (EBAY.)
There are two things that a technician can do once a divergence forms and prices start to drop. First, it is an opportunity for long traders to be proactive about their risk control. That may mean using tighter stops, protective options or just reviewing your portfolio to make sure you are properly diversified.
Second, a bearish divergence is a great timing signal for more speculative traders to get short the market or to buy put options. In either case, the signal has given you actionable information for your own portfolio management.
