Trading divergence patterns is not a complete trading strategy rather it is an additional tool in the technical trading toolkit of any trader. Divergence is simply the disagreement between the price action and the indicator movement.
Now any oscillator can be used to show divergence patterns. The most commonly used oscillators include RSI, Stochastics, MACD, CCI, ROC and Williams %R. However, any oscillator can show divergence with price action.
There are two type of divergences, 1) Regular Divergence and 2) Hidden Divergence. The primary and the most common is the regular divergence. Again there are two type of regular divergences; 1) Bullish Divergence and 2) Bearish Divergence.
In case of Bullish Regular Divergence prices make a lower low while the oscillator makes a higher low whereas in case of Bearish Regular Divergence price makes a higher high while the oscillator makes a lower high.
When this regular divergence pattern appears on the chart it means that the price action is losing its momentum which in turn means a potential trend reversal or consolidation. When you spot a regular divergence pattern appearing on the chart, you should not ignore it as it is a warning that a potential trend reversal can take place.
Now, the case of the hidden divergence is the exact opposite. Regular divergence patterns indicate potential trend reversal whereas the hidden divergence patterns indicate trend continuation. Again just like the regular divergence patterns, there are two hidden divergence patterns.
In case of the Bearish Hidden Divergence, price action makes a lower high while the oscillator makes a higher high. While in case of the Bullish Hidden Divergence, price action makes a higher low while the oscillator makes a lower low. In a bearish hidden divergence price is in a downtrend. Appearance of the bearish hidden divergence pattern means continuation of the downtrend.
In the same manner, when the oscillator diverges from the prices in an uptrend in a bullish hidden divergence pattern, it means continuation of the uptrend. Some traders believe that the hidden divergence pattern is a far more trading signal than a regular divergence.
Spotting these patterns is now easy. You can use a divergence pattern recognizer indicator. There are charting software also that will send sms alerts on the appearance of a regular or a hidden divergence. You need to keep this in mind that divergences is not a complete trading system in itself. You will have to use other indicators in conjunction for entry and exit. However, looking for divergence for confirmation can increase your chances of success greatly.