Divergences are one of my favourite trading ideas because, when used in conjunction with other tools and ideas, they produce high-quality, extremely dependable trade signals.
When it comes to divergences, indications like price action are somewhat sluggish, but as we will see below, this lagging characteristic will actually help us find better and more reliable trade entries. Both trend-following and reversal traders can use divergences in trading to time their exits.
One of my setups heavily relies on divergences in trading, and they combine well with other indicators in my trading system. Although I don’t recommend trading divergences on their own, they are fine to start with.
What Does Trading Divergence Mean?
Let’s begin by defining a divergence and discussing what it indicates about price.
A trading divergence appears on your chart when the price rises but the indicator you are employing yields a lower high. When your indication and price changes diverge, it signals that “something” on your charts is happening that requires your attention but cannot be seen by simply looking at them.
When your indicator does not “agree” with price movement, there is a divergence in trading. Although this is a very basic introduction, it’s important to start someplace. Later, we will discuss more advanced divergence principles and how to trade them.
What Does Forex Divergence Mean?
The discrepancy in readings from two or more associated data sources is referred to as “divergence in forex.” A mismatch between price peaks and valleys and trading indicator peaks and valleys is known as divergence in forex.
Imagine being in the cockpit of an aeroplane and the gauges suddenly start to show that you are losing altitude quickly. While this is happening, the sky outside the window is clear, and you can see that the plane is in good condition. In forex, this is referred to as divergence.
Various Divergence Patterns in Trading
It’s crucial to keep in mind that there are several kinds of divergence in trading. To enter the market more effectively, you must be able to identify and differentiate the various types of divergences that occur in Forex at various times. Let’s examine each category separately.
Regular divergence indicates a trend reversal. It might be wise to sell short or buy long at this time. In the event that trading divergence is negative, the price chart will get ready for a downward trend. Traders in forex should prepare to sell. When there is a bullish divergence, it is worth getting ready to buy because the chart will rise. Divergence in forex can appear in a variety of ways. The oscillator must be correctly used to determine its kind, which is the most crucial step.
In order to identify bearish divergence in trading, a trader needs look at the price highs and the corresponding indication. When certain conditions are satisfied—a high should emerge on the price chart and the indicator should show a lower high—a conventional bearish divergence in trading will take place.
When determining the traditional bullish divergence, the indicator’s and the chart’s lows should be taken into account. The candlesticks will display a lower price value during a typical bullish divergence in the market, while the indicator will display a higher low. In this case, higher movement should be expected, thus the trader should get ready to buy.
Extended Forex divergence looks similar to classic divergence. The pattern it produces, however, resembles a “double bottom” or “double top.”
Graphical statistics make everything obvious, but how can you determine the direction of the market if the indicators reveal a second low or high that is significantly different from the terminal’s lowest and highest prices? The price will continue to move in the same direction if this characteristic is seen.
There is only one conclusion to be drawn from a prolonged negative divergence on the chart: Prices will continue to decline, and you should look for a selling opportunity. To identify the extended bearish divergence, the trader should pay close attention to the peaks (highs) on both the chart and the indicator.
During a significant move, this form of divergence is typically found towards the tops. The second price peak may be slightly higher or lower than the first, even though the market forms a double top. Even if the top levels are the same, the indicator will still show a lower second high. The double top of the price chart will not be drawn by the indicator.
If the chart displays an extended bullish divergence, you should look for a purchasing opportunity as the price increases. Look for the lower half or lows of both the price and the basement indication in order to identify a prolonged bullish divergence in the terminal. During a prolonged bullish divergence, quotes typically form a double bottom.
Hidden divergence points to the trend’s persistence. In a trade terminal, it is more challenging to find. If there is hidden divergence, it is obvious whether to start trading buys or sells. The price chart will likely keep moving downward if there is a hidden bearish divergence in the market. If there is a hidden positive divergence on the chart, the price will rise.
You must first be able to identify the candlestick peaks or price highs, as well as the indicator, in order to notice the concealed bearish divergence in trading (see How to read candlestick charts). The MACD indicator can be used to find hidden divergence. This situation only comes to pass when the price decreases. If the indicator is currently diverging, a downward trend is probably in store for the near future.
To find hidden bullish divergence, pay attention to both the indicator and the chart’s lows. This kind of divergence occurs when the market is moving upward and making high lows while the indicator is reading lower.
How Does Trading Divergence Work?
A shift in the indicator’s direction is interpreted by day traders as a signal that the price will soon follow. The oscillator is employed here as a leading price indication.
Divergence in trading is used to analyse market prices with the theory that the signal denotes a slowing of price velocity. This is due to the fact that the momentum of the price will usually change before the actual price.
If you throw a frisbee into a strong wind, it will first fly against the wind, then it will slow down, and then it will ultimately change direction and fly with the wind.
Best Trading Divergence Indicator
There is no one best indicator for detecting divergence in trading. Each technical indicator has a unique mix of benefits and drawbacks. The RSI, MACD, and Stochastic indicators—the top three—will be discussed.
Trading Divergence Strategies
RSI for Trading Divergence
The RSI indicator, also called an underlay indicator, is a momentum indicator displayed below the candlestick chart as an oscillator with a range of 0 to 100. By averaging price changes over the previous 14 periods, the RSI is calculated. The book “New Concepts in Technical Trading Systems” was written by J. Welles Wilder Jr.
The indicator creates a smooth line that usually tracks the price trend, which makes it perfect for trading divergence. When adjusted to the default 14-period value, the RSI indicator also provides few overbought and oversold signals. As a result, divergence as a trading signal produces fewer indicators, but those that do appear are more trustworthy.
MACD for Trading Divergence
An effective momentum indicator for trend-following scenarios is the MACD. The trend indicator displays a signal line and a histogram that shows the deviation between two moving averages. As the trend continues, the moving averages will converge and diverge before finally reversing.
The histogram’s visual attractiveness makes it a good tool for trading divergence, but after a new “swing point” has been formed, it becomes harder to comprehend. Check the validity of trend trade signals because the MACD lacks defined overbought and oversold zones. By effectively using previous MACD peaks as points of support and resistance, this can be overcome.
Stochastic for Trading Divergence
A technical momentum indicator called the stochastic divergence compares the most recent closing price to a range of prior values over the previous 14 periods. Because stochastic is a more sensitive indicator, it will offer more trading indication divergence and hence more trading opportunities, but it will also offer more false signals.
Is Trading Divergence Profitable?
Yes, it is financially rewarding, but not always! It’s crucial to remember that price activity is filtered using indicators. Depending on the terms of the exchange, the filter can help us either focus on or miss what’s vital.
Divergence serves as a trading signal before the price trend has changed, which is the main advantage of using it to decide when to enter a trade. Because of the early signal, the trader receives a better entry price for their deal.
Divergence in trading as part of a sound strategy has the problem of occasionally producing “false signals.” This happens when the indicator reverses course but the price trend does not do so as the indicator had anticipated. When the indicator becomes severely overbought or oversold, this frequently happens. Although the trend will continue, its momentum will decrease.
How Can I Verify Trading Divergence?
There are certain time-tested techniques for lowering false signals and raising the proportion of profitable trades. Here are various ways that we can learn about trade divergence:
Only take into account divergence signals that point in the trend’s long-term direction. alternatively, in a rangebound sideways market. For instance, in a bearish market, only consider RSI indicators, and in a bullish market, only consider RSI signals.
Before making a deal, always wait for the candle that indicates the divergence in Trading to close. Based on the state of the candle at the moment, indicators will provide a signal. If the candle closes differently, a trade signal resulting from divergence can disappear just as fast as it appeared.
The signal may also be supported by additional indicators, such as support and resistance levels, round numbers, pivot points, or a price action trading pattern.
How Should I Trade Divergence?
If you currently utilise indicators like the RSI or MACD to identify overbought and oversold levels, divergence in trading might be a beneficial addition to your trade plan. However, it shouldn’t primarily rely on trade divergence, and doing it right requires skill.
A divergence in trading does not always lead to a sharp reversal; in fact, the price typically moves into a sideways consolidation after a divergence. Keep in mind that a divergence just denotes a lack of momentum, not a complete trend change.
To prevent trade entries that go nowhere, you should expand your set of criteria and confirmation techniques. Divergences by themselves are insufficient, and many traders have experienced unsuccessful trading when using only divergences. Similar to any other trading strategy, you’ll need to add more confluence factors to your system to make it more effective.
The chart below shows how price formed two divergences but did not ever go down. The divergences therefore only helped to emphasise recent consolidation.
How to Make the Best Use of Divergence in Trading
Divergence is a tool used by traders to determine if a trend is waning, resulting in a trend reversal or continuance. Before you go out and start looking for potential divergences, consider these nine good trading principles that will help you understand how to use them:
Clarify your eyewear
The price must have developed one of the following patterns for there to be a divergence in trading:
- greater high than the earlier high
- reduced low compared to the prior low
- Triple Top
- Two Bottoms
- Positive Tops and Bottoms
Now that you have it, look at the recent price movement. You should keep in mind that there are only four outcomes: a higher high, a flat high, a lower low, or a flat low.
From that high or low, trace a line back to the one before it. It must be on consecutive significant tops or bottoms.
If you experience any minor peaks or valleys in between the two major highs and lows, ignore them just as you would when your partner yells at you.
links the TOPS and the BOTTOMS
As soon as two swing highs are achieved, you link the TOPS. If two lows are made, THE BOTTOMS ARE CONNECTED.
Watch for price changes
A trend line linking two tops or bottoms has thus been drawn. Examine your preferred technical indicator in relation to the price activity. Keep in mind that, depending on the indicator you’re using, you are comparing the TOPS or BOTTOMS.
Consistency, Highs and Lows, and Swings
You must also draw a line between the two highs on the indicator chart if you draw a line between two highs on the price chart. Lows are comparable to highs in this regard.
Maintain Price and Indicator Verticle Alignment
The highs and lows you note on the indicator MUST VERTICALLY MATCH the highs and lows of the price.
Keep the price’s swing highs and lows and the indicator’s swing highs and lows vertically aligned.
Existence of divergence can be determined by comparing the slopes of the lines connecting the tops and bottoms of the indicator and the price. The slopes should be going up or down.
The next trade divergence should be regarded as having occurred if you observe one but the price has already reversed and moved steadily in one direction.
Retract your steps with Wrong Signals
Divergence signals are more accurate over larger time intervals. As a result, there are less incorrect false indications. This means fewer transactions, but if your trade is well-structured, your profit potential can be very high. There will be more instances of shorter-term divergences, but they won’t be as reliable.
Trading divergence is a method for quickly spotting a trend reversal indication. Divergence is also seen on volume indicators. Technical indicators can’t match its impact. The foundations of divergence trading, however, apply to all indicators equally. The three types of divergence are regular, extended, and hidden. To find the divergence, you can use the MACD, CCI, Stochastic, or other oscillators. Use any confirming indication to boost your trading’s likelihood of success. Choose a commission-free broker like PrimeFin if you want trading ideas, trading techniques, and high-quality forex trading with Divergence.
What are the greatest trading indicators for divergence?
- CCI and MACD indicators
- tempo indicator
- Dynamic indicator
- Q2 MFI indication What distinguishes divergence from convergence in trading?
Divergence is the term used to describe when the price of a stock and an indicator diverge. Contrarily, convergence refers to the movement of an asset’s price and an indicator in the same direction. Divergence is used by technical traders as a trading signal, but the absence of convergence creates a chance for arbitrage.
How Can Divergence Be Used in Trading?
- Clarify your eyewear
- Create an effective top-to-bottom line.
- connects the lines on TOPS and BOTTOMS.
- Watch for price changes
- Swing Variable Consistency
- Maintain the swinging of the price and indicator vertices.
- Q4. Which oscillator is the best for detecting divergence in trading?
The strongest indicator for divergence patterns is the Awesome Oscillator, while there are others like MAD, RSI, CCI, or stochastic.