Divergences are one of my favorite trading concepts because, when paired with other trading tools and concepts, they provide very reliable, high-quality trading signals.
Although indicators, like price action, are somewhat lagging, when it comes to divergences, this lagging feature will actually help us locate better and more dependable trade entries, as we will see below. Divergences in Trading can be used by reversal traders and trend-following traders to time their exits.
Divergences in Trading are a significant part of one of my setups, and they work well with other indications in my trading system. I don’t advise trading divergences independently, but they are good to start.
What is Divergence in Trading?
Let’s start with the initial question: what is a divergence, and what does it tell you about price?
On your chart, a divergence in trading occurs when the price reaches higher while the indicator you are using produces a lower high. When your indicator and price changes are not in sync, it suggests “something” is going on on your charts that needs your attention, but it’s not clear from just looking at them.
A divergence in trading occurs when your indicator does not “agree” with price movement. Granted, this is a very basic overview, and we will go into more complicated divergence concepts and how to trade them later, but it’s vital to start somewhere.
What is Divergence in Forex?
The term “Divergence in Forex” refers to the difference in readings from two or more correlated data sources. Divergence in Forex is a mismatch between price peaks and valleys and indicator peaks and valleys in trading.
Imagine being in the cockpit of an airplane, and the indicators suddenly begin to indicate that you are rapidly losing altitude. At the same time, the weather is clear outside the window, and you can see that the plane is in good working order. This is what we call divergence in Forex.
Types of Divergence in Trading?
It’s important to remember that there are various types of divergence in trading. You must be able to recognize and distinguish the many forms of divergences in Forex on different periods to enter the market more correctly. Let’s take a look at each type independently.
You can detect a trend reversal with regular divergence. This is an excellent opportunity to sell short or purchase long. The price chart will prepare for a downward trend if the divergence in trading is negative. Forex traders should get ready to sell. It’s worth getting ready to buy when there’s a bullish divergence since the chart will go up. Divergence in Forex can take several forms. The most important thing is to use the oscillator to establish its type correctly.
A trader must look at the price highs and the associated indicator to spot bearish divergence in trading. A traditional bearish divergence in trading will occur when specific characteristics are met: a high should form on the price chart and the indicator should show a lower high.
The lows of the chart and the indicator should be considered when determining the classic bullish divergence. When there is a normal bullish divergence in the market, the candlesticks will show a lower price value, but the indicator will show a higher low. In this instance, we should anticipate higher movement, which means the trader should prepare to buy.
Extended Forex divergence resembles traditional divergence in appearance. On the other hand, it creates a pattern that resembles a “double bottom” or “double top.”
Everything is evident with graphical numbers, but how can you tell which way the market is going if the indicators show a second low or high that is substantially different from the terminal’s lowest and maximum prices? If this characteristic is observed, the price will remain in the same direction.
If the chart shows an extended bearish divergence, it can only suggest one thing: prices will continue to fall, and you should search for a selling opportunity. The trader should pay attention to the peaks (highs) on both the chart and the indicator to determine the extended bearish divergence.
This kind of divergence is usually found near the tops during a major move. Although the market forms a double top, the second price peak may be somewhat higher or lower than the first. The indicator will display a lower second high even if the top levels are the same. The indicator will not draw the price chart’s double top.
If you see an extended bullish divergence on the chart, you should seek a buying opportunity as prices rise. To spot an extended bullish divergence in the terminal, look for the lower half or lows of both the price and the basement indication. Quotes usually form a double bottom during an extended bullish divergence.
The continuation of the trend is indicated by hidden divergence. It is more difficult to spot in a trading terminal. Hidden divergence clearly indicates whether to open a buy or sell position. If there is a concealed bearish divergence in the market, the price chart will likely continue to trend downward. The price will climb if there is a concealed positive divergence on the chart.
To spot the hidden bearish divergence in trading, you must first recognize the candlestick (How to read candlestick charts) peaks or price highs, as well as the indication. Hidden divergence can be detected using the MACD indicator. Only when the price falls do this scenario materialize. If the indicator currently displays a divergence, a downward trend is likely in the future.
You must pay attention to the chart’s lows as well as the indicator to detect concealed bullish divergence. When the market is moving upward, drawing high lows and the indicator is reading lower, this type of divergence happens.
How Divergence in Trading Work?
Day traders interpret a change in the indicator’s direction as a sign that price is about to follow. In this case, the oscillator is used as a leading price indicator.
The idea behind using divergence in trading to analyse market prices is that the signal indicates a decrease in price velocity. This is because the price’s momentum will frequently alter before the price itself.
Consider throwing a frisbee into a high wind: the frisbee will initially fly against the wind, then slow down, then finally change direction and fly with the wind.
Best Divergence in Trading Indicator
There is no single most preferred indicator for divergence in trading. Every technical indicator has its own set of advantages and disadvantages. The three most popular indicators will be covered: RSI, MACD, and Stochastic.
Strategies of Divergence in Trading
RSI for Divergence in Trading
The RSI indicator, also known as an underlay indicator, is a momentum indicator drawn as an oscillator between 0 and 100 beneath the candlestick chart. The RSI is determined by taking the average of price changes over the past 14 periods. J. Welles Wilder Jr created “New Concepts in Technical Trading Systems”.
The indicator generates a smooth line that tends to follow the price trend, making it ideal for divergence in trading. In addition, the RSI indicator delivers few overbought and oversold indications when set to the default 14-period value. That means that while there are fewer signs when utilising divergence as a trading signal, they are more reliable when they do occur.
MACD for Divergence in Trading
The MACD is a momentum indicator that performs well in trend-following situations. A signal line and a histogram depicting the difference between two moving averages are plotted by the trend indicator. The moving averages will converge and diverge as the trend proceeds, finally reversing.
The histogram’s visual appeal lends itself well to trading divergence, but it is less interpretable once a new ‘swing point’ has been established. Because the MACD has no pre-defined overbought and oversold zones, determine whether trend trade signals are reliable. This can be overcome by properly utilizing prior MACD peaks as locations of support and resistance.
Stochastic for Divergence in Trading
The stochastic Divergence is a technical momentum indicator that compares the most recent closing price to a range of previous prices over the preceding 14 periods. Because stochastic is a more sensitive indicator, it will provide more divergence in trading indications and thus more trading possibilities, but it will also provide more false signals.
Is Divergence in Trading Profitable?
Yes, it is profitable, but it is not always the case! It’s important to note that indicators are used to filter price action. Depending on the trade arrangement, the filter can assist us to focus on what’s crucial or missing what’s important.
The main benefit of employing divergence as a trading signal for determining when to enter a trade is that it provides the signal before the price trend has altered. The trader gets a better entry price for their transaction because of the early signal.
The drawback of employing divergence in trading as part of a good method is that it can produce “false signals.” This occurs when the indicator switches direction, but the price trend does not reverse as predicted by the indicator. This frequently occurs when the indicator becomes extremely overbought or oversold. The trend’s momentum will wane, but the trend will continue.
How to Confirm Divergence in Trading?
There are certain tried-and-true methods for reducing false signals and increasing the number of profitable trades. These are some points by which we come to know about divergence in trading:
- Only consider divergence signs in the long-term direction of the trend. Alternatively, in a sideways market that is rangebound. For example, In a negative market, only take bearish RSI indications and only take RSI signals in a bull market.
- Always wait for the candle that confirms the divergence in Trading to close before entering a trade. Indicators will offer a signal based on the candle’s present state. A trading signal from divergence might vanish as quickly as it appeared if the candle finishes differently.
- Other indications, such as support and resistance levels, round numbers, pivot points, or a price action trading pattern, might be used to confirm the signal.
How to Trade with Divergence?
Divergence in trading can be a useful addition to your trade strategy, especially if you are already utilizing indicators like the RSI or MACD to detect overbought and oversold levels. However, it shouldn’t rely solely on trading divergence, and it takes practice to do it correctly.
A divergence does not necessarily result in a violent reversal; in fact, the price frequently enters a sideways consolidation after a divergence in trading. Remember that a divergence indicates a lack of momentum and does not imply a complete trend shift.
Other criteria and confirmation methods should be added to your arsenal to avoid trade entries that don’t go anywhere. A divergence by itself is insufficient, and many traders have had poor results when trading just with divergences. You’ll need to incorporate more confluence factors to make your method stronger, just like any other trading technique.
We can see how price made two divergences but never sold off in the chart below. As a result, the divergences only served to highlight short-term consolidation.
How to Use Divergence in Trading in the Best Possible Way?
Traders use divergence in trading to figure out if a trend is weakening, leading to a trend reversal or continuation. Here are nine excellent principles for trading divergences by which a trader come o know how to use divergences in trading before you go out and start hunting for probable divergences:
Clean your Glasses
To have a divergence in trading, the price must have formed one of the following patterns:
- Higher high than the previous high
- Lower low than the previous low
- Double Top
- Double Bottom
Successful Tops and Bottoms
- Take a look at the recent price action now that you have it. Remember, there are only four possibilities: a higher high, a flat high, a lower low, or a flat low.
- Draw a line from that high or low back to the previous high or low. It has to be on major tops/bottoms in a row.
- If you notice any minor bumps or dips between the two major highs/lows, disregard them like you would when your significant other yells at you.
Connects TOPS and BOTTOMS
You link the TOPS once two swing highs are made. The BOTTOMS are connected if two lows are made.
Keep an eye on Price Changes
So you have drawn a trend line connecting two tops or two bottoms. Take a look at your favourite technical indicator and see how it compares to price action. Remember that you are comparing the TOPS or BOTTOMS of whichever indicator you’re using.
Swings Highs and Lows Consistency
If you create a line between two highs on the price chart, you must also draw a line between the two highs on the indicator chart. The same may be said or done for lows.
Keep Verticle Alignment of Price and Indicators Swing
The highs and lows you identify on the indicator MUST VERTICALLY correspond to the price highs and lows.
Maintain vertical alignment with the swing highs and lows of the price and the swing highs and lows of the indicator.
If the slope connecting the indicator tops/bottoms differs from the slopes of the line connecting the price tops/bottoms, does divergence exist. The Slopes should be ascending or descending.
If you got success, Catch next
If you see a divergence in trading, but the price has already reversed and moved in one direction for a long period, you should consider the next divergence in trading to have played out.
Take a step back on Wrong Signals
On longer time frames, divergence signs are more accurate. There are fewer erroneous wrong signals as a result. This means fewer deals, but your profit potential can be enormous if your trade is well-structured. Shorter-term divergences will occur more frequently, but they will be less trustworthy.
Divergence in trading is a technique for detecting a trend reversal signal early on. Divergence can be seen on volume indicators as well. It has a greater influence than technical indications. However, the fundamentals of divergence trading are the same for all indicators. Regular, extended, and hidden divergence are the three forms of divergence. You can use the MACD, CCI, Stochastic, or other oscillators to discover the divergence. Any confirmation signal should be used to increase your trading’s chances of success. If you want trading ideas, trading strategies, and high-quality forex trading with Divergence, then you should prefer a commission-free broker like PrimeFin.
Q1. What is the best Divergence in Trading Indicators?
- MACD indicator
- CCI indicator
- Momentum indicator
- Stochastic indicator
- MFI indicator
Q2. Difference between Divergence and convergence in trading?
When the price of a stock and an indicator diverge, it is called divergence. Whereas, When the price of an asset and an indicator move in the same direction, this is known as convergence. Technical traders are involved in divergence as a trading signal, whereas the lack of convergence provides an arbitrage opportunity.
Q3. How to Use Divergence in Trading?
- Clean your Glasses
- Draw a successful line of tops and bottoms.
- Connects TOPS and BOTTOMS lines.
- Keep an eye on Price Changes
- Swing High and low Consistency
- Keep Verticle Alignment of price and indicators swing.
Q4. Which is the Best Oscillator for Divergence in trading?
The Awesome Oscillator is the best indicator for divergence patterns, although others include MAD, RSI, CCI, or stochastic.