Being a forex trader, you need to look at the charts all the time and have command over its reading and interpretation skills. These charts hold a unique world of possibilities and opportunities in themselves that needs to be explored. To benefit from these opportunities you need to know the basic tools and indicators to cash on these opportunities. One of the most important technical analysis indicators that need to be a part of your toolset is to know about divergence trading.
Divergences – Definition
Divergences appear on a bar chart when the price of a stock and its underlying asset, indicator or index starts moving in the opposite directions. In order to make transaction decisions by identifying situations of divergence, learning divergence trading can help you sell near the top and buy near the bottom of a trend in a low-risk way.
Divergences can be identified by comparing price action and the movement of an indicator (it could be MACD, CCI, RSI etc). This toolset helps you know ahead of time the perfect time and place to exit the market, if you are in a long position, as the market is about to take a reversal position.
One of the reasons why divergence trading is considered to be extremely useful by traders, analysts, and brokers is that they can be used as leading indicators, which are not that difficult to spot if you have done enough amount of practice and can provide you with consistent profits.
Technical Analysis – Positive and Negative Divergence
Divergence is considered to be positive or negative in technical analysis. These divergences indicate that the price is about to experience a major shift in the market. When the indicator starts to climb but the security’s price makes a new low then this shows the occurrence of positive divergence. Whereas, when a security’s price makes a new high, but the indicator doesn’t follow the same trend and instead closes lower than the previous high then a negative, divergence happens.
Price and momentum usually move in the same directions such that both of them would together make higher highs or make lower lows. If this is not happening then it is a clear prediction of a divergence, which might be a weakening trend or a reversal that is soon expected to take place.
Types of Divergence
Using divergence trading is as useful as using other tools in your forex toolset and can be even used to signal for a trend to continue apart from its use for identifying reversal patterns.
There are two types of divergences, which are further subdivided into two each, which are commonly used which are discussed as follows.
Regular divergence is also known as the classic divergence and is used to identify trend reversal. It indicates that the trend might soon end as a weakness in the price action has been noticed. Although it shows a probable trend reversal, it does not give the exact time as to when this could happen.
To identify the exact timing of this reversal, divergence trading can be used in combination with trend lines, candlestick patterns, or other forex tools.
This regular divergence is further sub-divided into two types which are explained below.
Regular Bullish Divergence
A regular bullish divergence, also known as a positive divergence, occurs when the price is making lower lows but the oscillating indicator is making higher lows. This usually happens at the end of a downtrend, when after setting the second bottom the oscillating indicator does not make a new low which is a sign that the situation is about to reverse.
A reversal is always in place when the price and momentum do not move in the same direction as they are normally expected to move in line with each other. To understand regular bullish divergence better, below is a simple image that clearly shows the formation of this pattern.
Regular Bearish Divergence
A regular bearish divergence, or a negative divergence, occurs in an uptrend when the price makes higher highs, but the oscillator is making lower highs. After the price makes second high, but the oscillator makes a lower high, you can expect a reversal in prices where they would start to drop.
Below is an image for you to better understand this concept.
As the name indicates, hidden divergences, are not actually concealed rather they are hidden inside the current trend of the market. They not only are helpful for identifying potential trend reversal but also are most commonly used to look for a sign that indicates possible trend continuation.
These hidden divergences often tend to occur during corrections or consolidations in an existing trend and generally indicate that there is still strength in the direction in which the market is trending and that it will resume.
Just like regular divergences, hidden divergences are also further sub-divided into bullish or bearish patterns.
Hidden Bullish Divergence
Hidden bullish divergence occurs when there is a correction taking place in an uptrend and the oscillator is making a higher high whereas the price is in its correction or consolidation phase. This indicates that there is still strength in the current pattern and the correction is merely profit taking which is unlikely to last, rather than the appearance of strong selling sentiment in the market.
Another situation is when the price makes a higher low but the oscillator is making a lower low. This is a hidden divergence that needs to be identified immediately to make the most of this opportunity in our hands.
Below is a graphical depiction of this situation.
Hidden Bearish Divergence
Finally, here is the last type of divergence which is the hidden bearish divergence. This occurs during a downtrend when the oscillator shows a lower low but the price does not follow the same direction. This situation in the market and on the charts indicates that market is still strong on the downtrend and that selling sentiment is still prevailing among the market participants. This is basically happening because of profit taking and is therefore short-lived.
Another situation is when the oscillator makes a higher high but the price makes a lower high which is an indication of hidden bearish divergence and there is a possibility for it to shoot lower and continue the downtrend.
Below is a graph for you to better understand this concept.
Rules for Trading Divergences
For you to make better trading decisions, and use your toolset of divergence trading efficiently and effectively while looking for potential divergences, here are nine absolutely important rules that you should learn and apply.
Rule # 1
Look for a pattern and a divergence to exist in order to trade as per the divergences. Otherwise, there is no use of looking for an indicator. It is necessary that the price forms at least one of the following and is clearly evident on the chart.
- Double top
- Double bottom
- Lower low than the previous low
- Higher high than the previous high
If any of these scenarios occur then do bother to look an indicator as there might be a chance that you would be trading a divergence.
Below we have shared real chart examples for you to better understand the difference.
Example of higher high than the previous high where it is a yes signal to trade a divergence
Example of corrections and consolidations in the price, where there is no sign of a divergence.
Rule # 2
If you want to notice a pattern where divergence is about to take place then it is necessary to draw lines and connect them to form successive tops and bottoms. You will notice one of these four patterns
- A higher high
- A lower low
- A flat high
- A flat low
Draw a line and connect the most recent high (or low) with the previous high (or low) to witness major successive tops (or bottoms). If only small bumps appear between the two then it is better not to assume it as a divergence.
Rule # 3
Always and always connect only the tops of two swing highs that are established or connect the bottoms of the two lows that are made. To understand this we have presented 2 charts that indicate these two situations.
The chart below connects two highs, with the recent high higher than the previous high. This is a yes signal of trading a divergence.
This next chart below shows two lows which are almost equal to each other with the recent low not that lower than the previous one, hence it is not recommended to use a divergence trading strategy here.
Rule # 4
Once you have connected either the two tops or the two bottoms, it is time for you to select a preferred indicator and then compare its movement to the current price action in the market. Always keep in mind that you are comparing only the tops and bottoms with your selected indicator, and not the other lines that some of these indicators might form in between, so you need to only focus on it.
Rule # 5
This is one of the most important rules that indicate a similarity between the price and the oscillating indicator. This can be best understood with the help of some graphs.
The graph above shows two high on prices that are connected by a line is also connected with the help of a line on the indicator as well. Same goes for the two lows and the indicator as well. These lines must match for you to take a decision to apply divergence trading strategies and tools.
The graph above is not a good indicator of divergence.
Rule # 6
Your highs and lows on the indicator must always be in a vertical line to the price highs and lows. This is necessary for the prediction of a possible divergence and to trade on the basis of this possibility.
The graph below indicates how these two should match vertically.
Rule # 7
For a divergence to occur it is necessary that the slope of the line connecting tops/ bottoms of the selected indicator differ from the slope of the line connecting tops/ bottoms of the price. It is essential for the slope to be flat, ascending (rising) or descending (falling).
Below is a chart the clearly depicts the formation of ascending and descending slopes.
Rule # 8
It is never too late in the forex market to cash on an opportunity since it is a recurring market. There might be times where you might be able to spot a divergence but the reversal of price has already taken place and has moved in the same direction for quite some time. This is when you should consider the divergence that has sailed out of your hand. But there is no need to give up on this! There might be another one that is about to take place and form through swing highs or swing lows.
Rule # 9
Signals of divergence between price and oscillating indicators tend to be more accurate when analyzed on longer time frames as they would occur once in a while. On shorter time frames, divergences would be less reliable as they would occur more frequently and difficult to interpret.
Although basing your trading on divergences opportunities from longer timeframes means fewer trades but your profit potential can be huge if you are able to structure your trade well.
It is always advised by forex gurus and professional traders of this field to look for divergences on 1-hour charts or longer as other traders use 15-minutes charts when basing their trading decision on other tools of the forex world. It is believed that there is too much noise for a divergence to be appropriately identified.
So here you have it! What divergence trading really are and the rules you need to spot some juicy divergence opportunities.
Source of Graphs