How To Trade Divergences
Types Of Divergences
A day trading strategy that is particularly well-liked among forex traders involves using the divergence of a technical indicator from the movement in a market price. Day traders interpret an indicator's direction change to indicate that the price may soon follow.
Divergence is a technique used in technical analysis when an oscillator or other technical indicator deviates from the general price trend. The trading oscillator signals a potential trend reversal when the indicator moves in the opposite direction from the price.
In this case, the oscillator serves as a leading price indicator. Divergence is used to analyse market price because the indicator shows a slowdown in price momentum. Often, the price's momentum will change before the actual price.
Types of Divergences
You must be able to recognise and differentiate between the various types of Forex divergences on various timeframes to trade more accurately. Let's examine each type in isolation.
Regular divergence
A trend reversal can be seen when there is regular divergence. A good time to sell short or buy long is now. If the divergence is bearish, the price chart will move downward. Forex traders need to get ready to sell. It is wise to get ready to buy when there is a bullish divergence because the chart will rise. By the way, there are various examples of divergence in the forex market. The key is using the oscillator to identify its type correctly.
Regular Bearish Divergence
A trader must examine the price highs (the shadows of Forex candles) and the corresponding indicator to spot bearish divergence in the market. When two requirements are met:
Check for a high on the price chart
The indicator should display a lower high. It is a typical bearish divergence will happen.
However, looking for larger maximum price values on the chart is not required. The preceding peak is a little bit lower than the next peak.
Regular Bullish Divergence
It would help if you looked at the chart's lows and the indicator to spot the traditional bullish divergence in Forex. The candlesticks will depict a lower price value, and the indicator, on the other hand, will depict a higher low if the market is experiencing a regular bullish divergence. An upward trend is anticipated; hence, the trader must prepare to buy.
How to trade using regular divergence?
To determine the main trend and receive a confirmation to place a trade, you should utilise any trend indicator, such as the moving average. You could employ a simple moving average with a period of 20. You take a long position if there is a bullish divergence and the price exceeds the 20 SMA. The take profit can be close to the following resistance level, while the stop-loss can be positioned somewhat below the most recent swing low.
Hidden divergence in Forex
Hidden Forex divergence in the currency market provides information on the trend's prognosis. However, it can be challenging to spot it in a trading terminal. The presence of hidden Forex divergence provides a definite signal to start buying or selling.
The price chart will likely slow if there is a concealed bearish divergence in the market. The price will increase if there is a concealed positive divergence on the chart.
Hidden bearish divergence
It would help if you recognised the highs of the candlesticks or the price as well as the indicator to spot the concealed bearish divergence in Forex. Hidden divergence can be found using the MACD indicator. Only when the price decreases does this situation become possible. Future downward movement can be anticipated if the indicator now exhibits a divergence.
Hidden bullish divergence
The chart's lows and the indicator must be observed to spot concealed bullish divergence. When the market is moving upward and making high lows while the indicator is reading lower, there is a divergence of this kind.
How do we trade a hidden divergence?
Initiate the trade with a stop-loss near the most recent swing low/high and a profit objective close to the following support/resistance level if you spot a concealed divergence.
Which indicators leveraging divergence work the best?
Divergence can be detected using any oscillator indicator. The chosen indicator and the currency pairs have an impact on the findings, too. We have chosen the finest three oscillator indicators from them that can be quite useful for your trade.
Divergence trading using RSI
An underlay indicator, or momentum indicator, the RSI, is shown as an oscillator between 0 and 100 beneath the candlestick chart. The price gains and losses over the preceding 14 periods are averaged to get the RSI.
The indicator generates a smooth line that follows the price trend and is ideally suited for trading divergences. This means that although there are typically fewer signals, they are more trustworthy when they do occur when utilising divergence as a trading indicator.
MACD for divergence trading
The MACD is a momentum indicator that works best when trends are followed. The trend indicator plots a signal line and a histogram that displays the difference between two moving averages. The moving averages will converge and diverge as the trend develops and eventually turns around.
Stochastic for trading divergence
The stochastic technical indicator measures momentum and compares the most recent closing price to a range of prices from the preceding 14 periods. Because stochastic is a more sensitive indicator, it will provide more signals of divergence and, thus, more trading possibilities, but this also means that there will be more false signals.
How can divergence be verified?
There are various tried-and-true methods to minimise the number of false signals and maximise the number of profitable transactions.
- Divergence signals should only be acted upon in the long-term trend's direction. Alternatively, in a sideways market that is rangebound. For instance, only act on bearish RSI indications during a down market and only act on buying RSI signals during a bull market.
- Always watch for the closing of the candle that is verifying the divergence. Indicators will send out a signal based on the candle's current state. A trading signal from divergence might vanish as quickly as it appeared if the candle finishes differently.
- To validate the signal, use additional indications, such as pivot points, round numbers, support and resistance levels, or a price action trading pattern.
Rules for trading divergences
1. A price must have either formed one of the following for a divergence to exist:
- greater high than the earlier high
- reduced low compared to the prior low
- Top to bottom and back to top
If only ONE of these four price possibilities has occurred, don't even think about looking at an indicator.
2. Draw lines on successive tops and bottoms
Only one of the following four possibilities will be visible: a higher high, a flat high, a lower low, or a flat low.
Next, draw a line from high or low to high or low before that. It MUST appear on subsequent big tops or bottoms. When your significant other yells at you to disregard something, do the same if you notice any minor peaks or valleys between the two major highs and lows.
3. Only connect the TOPS and BOTTOMS.
You connect the TOPS once you perceive that two swing highs have been formed.
The BOTTOMS are connected if two lows are made.
4. Keep Your Swing Highs and Lows Consistent
If you draw a line between two price highs, you MUST also draw a line between the two indication highs, likewise for lows.
If you create a line joining two low points on the price chart, you MUST do so on the indicator. They must coordinate!
5. Maintain vertical alignment of price and indicator swings.
The highs or lows you note on the indicator MUST LINE UP VERTICALLY with the highs or lows of the price.
It's the same as choosing what to wear to a club—you have to look sharp and coordinate, yo!
Maintain vertical alignment between the PRICE and INDICATOR's swing highs and lows.
6. Observe the Slopes
Divergence occurs only when the slope of the line joining the tops and bottoms of the indicator DIFFERS from the slope of the line joining the tops and bottoms of the price.
Either way, the slope must be ascending (rising), Descending (falling) (falling), Flat (flat) (flat).
7. Catch the next ship if the first one has sailed.
The divergence should be viewed as played out if you notice it, but the price has already reversed and has been moving in one direction for some time.
This time, you were late. All that's left to do is wait for another swing, high or low, to form before resuming your search for divergences.
Why are divergences not a trading signal?
Divergence should not be relied upon only partially because it doesn't offer reliable trade signals. Long periods of divergence can pass without a price reversal taking place. Divergence is only present on some significant price reversals, not all of them.