How to Trade Divergences

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How to trade Divergences

In this article I will explain you what divergence is and how to trade it. For trading divergences we need only Price Action and one indicator. The indicator might be an oscillator like the RSI or the stochastic, might be a momentum indicator like CCI or the Momentum or finally you can trade Volume divergences with a volume indicator.

First of all, I want to say what divergence is. When the traders say “divergence” mean a disagreement between Price Action Signals and Indicators Signals. Let’s see our first screen shot. It’s from USDJPY currency pair.

As you can see in this chart I use only a 14 period RSI. Look the price behavior in the blue box. It makes higher- highs. Now, look at the RSI behavior. It makes higher- highs, too. In this case the price action and the oscillator agree. There is not a divergence. Take a look in the second screen shot. It’s from AUDUSD currency pair.

In this case, you can easily see that the price makes Higher- Highs but our 14 period RSI makes lower- highs. So, we have a disagreement here and there is a divergence. With the price making HHs and the oscillator making LHs we have a sell signal. In this case we have a mini up-trend and it’s time for a big reversal of the trend. Notice that after the disagreement we have a big movement down and the price finally stops moving down in the support near the whole number (the yellow horizontal line). If there is an opposite condition in which the price makes lower- highs and our indicator higher- highs there is again a sell signal.

I said above when we have bearish signals. Now, I am going to say when there are bullish signals. Take a look. It’s from EURUSD currency pair.

The price in the blue box makes lower- lows. Our indicator in the blue box makes higher- lows. There is a small disagreement here so there is also a small bullish divergence. Notice the bullish movement of the price after the reversal. In the opposite condition in which price makes higher- lows and our indicator makes lower- lows there is again a bullish signals.

You can use the indicator you want. In the charts I use the RSI. Divergence is a very strong tool and you should look for hidden divergences regardless of the strategy you are using.

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How To Trade Divergence In Forex

Trading divergence is one of the ways to trade on the Forex market. Although this strategy is not often applied, if used correctly it can be very profitable. Divergences are often used as important trading signals. But this does not mean that they will always predict the trend reversal correctly. The divergence of price oscillators has long been recognized by technical traders as a clear indicator of potential price reversals. Clearly visible divergence, especially on long-term charts, can be extremely accurate in many cases.

Divergence And Convergence In Forex

Convergence is the coincidence of the price chart and technical indicator. To make it simpler, it is when there is a downward trend in the price chart and the technical indicator, the heights also lower, i.e. a single direction. Graphically, it looks like this:

As can be seen in the figure above, the Awesome Oscillator (AO) is used to spot the convergence in this case. One can easily use the MACD oscillator, which is developed to determine this property, but it has a completely unsightly appearance in the trading platform because it is used for completely different purposes. So, the blue lines on the chart reflect the slopes of the current trends. And if you look at the slope of the price and indicator lines on the chart at the same time, you will see that they are moving in the same direction. Otherwise speaking, the readings converge.
Divergence is a difference between the price chart and technical indicator. In other words, it happens when there is an upward trend in the price chart and a descending trend in the technical indicator. That is, there is a different direction (slope). Graphically, it looks as follows:

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Again, we use the oscillator AO for spotting it. The divergence in the above figure is shown likewise to convergence. Just now we can see that the incline of blue lines on the price chart and the indicator has the contrary course. In other words, the readings differ, which is the principal definition of the divergence. There are a lot of practical properties of divergence. The foremost thing is, obviously, the fact that the divergence appears on the price chart exclusively at the times when the current trend weakens and goes into the shift stage. Put another way, divergence is one of the principal signs of a trend reversal.

Trading Forex Using Divergence

It is advisable to pay attention to 2 nuances – they will increase the efficiency of the trading.
Firstly, it is a fundamental analysis. Before opening any trade on a divergence, look through the news for the near future – isn’t there something important that can unpredictably affect the market? If there is such news, no one will be interested in technical analysis, and despite the divergence, quotes will easily go against it!
Secondly, calculate the volume of the trade in order not to lose more than 2% of the deposit. No matter how strong and correct the signal may seem, the capital should be protected. There will be a lot of positions, and no one will give you the capital for nothing.

Forex Divergence Trading System

Trading divergence is simple and effective enough, suitable for both experienced and novice traders. Divergence is a strong signal to open a position against the current trend.
To use this trading approach one can use any Forex asset with direct quotes: GBP/USD, USD/CHF, USD/JPY, AUD/USD, etc.
The state of divergence is spotted by MACD or RSI indicators. Recommended parameters of the indicators:

  • MACD (12,26,9) or (5,34,5).
  • RSI (indicator period14, averaging period 5)
  • The working time frame is 1H.

The specified parameters for the indicators have been obtained experimentally and are the most effective. However, each trader can choose them independently if he wants to get a clearer picture of divergence.
Then wait for the divergence to form on the trading interval chart. We determine the levels of a stop order and profit setting. Let us consider two options:

Formation of divergence when the resistance level is broken down

In this case, the stop order is set tentatively, depending on the volatility of the traded currency pair by 15-30 points for the level of the shadow of the previous candle. We set the profit at the level where the divergence began. In practice, this is a guaranteed target for the price. We should not hold a position against the trend any further.

Formation of divergence when the price bounces off the border of the trading channel

We expect the price and divergence indicator to appear on the chart. In this case, the protective order, depending on the volatility of the traded currency pair, is placed, as in the previous case, by 15-30 points for the level of the shadow of the previous candle. And the aim for gain is the middle of the trading channel. If the price does not bounce off the middle of the channel, we set an additional target, the second target is the opposite wall of the trading channel.

A buy/sell order is placed after a confirmation candle is formed.
Also keep in mind that good, clear market divergence is not a frequent phenomenon. There are many situations when a trader waits for additional confirmation to open a position. As a rule, in such cases, the trader misses the opportunity to enter the market at the best prices, because the divergence is usually worked out within 30 minutes on the hour chart. Therefore, if there is a good divergence on time, it is necessary to act decisively.

Conclusion

The method of trading divergence can be surprisingly effective for defining the moment of the main events in the Forex market when used in conjunction with other trading indicators. Divergences are often used as signals of possible turns and reversals. However, divergences are not often used as a completely self-sufficient trading strategy.

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Trading Divergence and Understanding Momentum

Because trends are composed of a series of price swings, momentum plays a key role is assessing trend strength. As such, it is important to know when a trend is slowing down. Less momentum does not always lead to a reversal, but it does signal something is changing, and the trend may consolidate or reverse.

Price momentum refers to the direction and magnitude of price. Comparing price swings helps traders gain insight into price momentum.   Here, we’ll take a look at how to evaluate price momentum and show you what divergence in momentum can tell you about the direction of a trend.

Key Takeaways

  • Price momentum is measured by the length of short-term price swings—steep slopes and a long price swing represent strong momentum, while weak momentum is represented by a shallow slope and short price swing.
  • Momentum indicators include the relative strength index, stochastics, and the rate of change.
  • Divergence—the disagreement between indicator—can have major implications for trade management.

Defining Price Momentum

The magnitude of price momentum is measured by the length of short-term price swings.   The beginning and end of each swing is established by structural price pivots, which form swing highs and lows. Strong momentum is exhibited by a steep slope and a long price swing. Weak momentum is seen with a shallow slope and short price swing. 

For example, the length of the upswings in an uptrend can be measured. Longer upswings suggest the uptrend is showing increased momentum, or getting stronger. Shorter upswings signify weakening momentum and trend strength. Equal-length upswings mean the momentum remains the same. 

Price swings are not always easy to evaluate with the naked eye because the price can be choppy. Momentum indicators are commonly used to smooth out the price action and give a clearer picture. They allow the trader to compare the indicator swings to price swings, rather than having to compare price to price.

Momentum Indicators

Common momentum indicators for measuring price movements include the relative strength index (RSI), stochastics, and rate of change (ROC).       Figure 2 is an example of how RSI is used to measure momentum. The default setting for RSI is 14.   RSI has fixed boundaries with values ranging from 0 to 100. 

Momentum can be calculated by using the formula:

Where CP is the closing price and CPx is the closing price “x” number of periods ago.

For each upswing in price, there is a similar upswing in RSI. When price swings down, RSI also swings down.

Figure 2: Indicator swings generally follow the direction of price swings (A). Trendlines can be drawn on swing highs (B) and lows (C) to compare the momentum between price and the indicator.

Source: TDAmeritrade Strategy Desk

The study of momentum simply checks whether price and the indicator agree or disagree.

Figure 3: Compare price and indicator to make better trading decisions.

Source: TDAmeritrade Strategy Desk

Momentum Divergence

Disagreement between the indicator and price is called divergence, and it can have significant implications for trade management.   The amount of agreement/disagreement is relative, so there can be several different patterns that develop in the relationship between price and the indicator. For this article, the discussion is limited to the basic forms of divergence.

It is important to note there must be price swings of sufficient strength to make momentum analysis valid. Therefore, momentum is useful in active trends, but it is not useful in range conditions in which price swings are limited and variable, as shown in Figure 4. 

Figure 4: In range conditions, the indicator does not add to what we see from price alone. Variable pivot highs and lows show range.

Source: TDAmeritrade Strategy Desk

Divergence in an uptrend occurs when price makes a higher high but the indicator does not. In a downtrend, divergence occurs when price makes a lower low, but the indicator does not. When divergence is spotted, there is a higher probability of a price retracement.   Figure 5 is an example of divergence and not a reversal, but a change of trend direction to sideways.

Figure 5: Momentum divergence and a pullback. Higher pivot highs (small orange arrows) signal price support.

Source: TDAmeritrade Strategy Desk

Divergence helps the trader recognize and react appropriately to a change in price action. It tells us something is changing and the trader must make a decision, such as tighten the stop-loss or take profit. Seeing divergence increases profitability by alerting the trader to protect profits.

Technical traders generally use divergence when the price moves in the opposite direction of a technical indicator.

Take note of the stock from Figure 5, Chesapeake Energy (CHK), in which shares pulled back to the support. The chart in Figure 6 (below) shows trends do not reverse quickly, or even often. Therefore, we make the best profits when we understand trend momentum and use it for the right strategy at the right time.

Figure 6: Trend continuation. Agreement between price and the indicator give an entry (small green arrows).

Source: TDAmeritrade Strategy Desk

Four Commonly Used Indicators In Trend Trading

Managing Divergence

Divergence is important for trade management. In Figure 5, taking profit or selling a call option were fine strategies. The divergence between the price and the indicator lead to a pullback, then the trend continued.   If you look at the pivot the price makes below the lower trendline, this is often referred to as a bear trap, where the false signal draws in shorts and price quickly reverses.   The signal to enter appeared when the higher low in price agreed with the higher low of the indicator in Figure 6 (small green arrows).

Divergence indicates something is changing, but it does not mean the trend will reverse. It signals the trader must consider strategy options—holding, selling a covered call, tightening the stop, or taking partial profits.   The glamour of wanting to pick the top or bottom is more about ego than profits. To be consistently profitable is to pick the right strategy for what price is doing, not what we think price will do.

Figure 7: Divergence results in range.

How To Trade With Hidden Divergences Video Tutorial

Divergence is an important leading signal.

A divergence signal develops when price leads or lags the indicator.

There are 2 types of divergences. Regular and Hidden.

Regular divergence is an important trend reversal signal.

Sometime it can be a retracement instead of a trend reversal.

However hidden divergence is more important than regular divergence.

Hidden divergence is always a trend continuation signal with a higher accuracy as compared to regular divergence.

You look for hidden divergence at the end of a retracement.

Hidden divergence tells you that the trend is going to continue in the original direction now.

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