Divergence definition forex
It is an oscillator like the Stochastic.
Trading Divergences in Forex -
Therefore, it is a good tool for spotting divergences on your chart. If you spot the pattern, it will provide for an early entry signal for your trade. The image below will show you how to trade divergence with the RSI indicator. At the bottom of the chart you see the Relative Strength Index indicator. The chart shows lower bottoms, while the RSI shows higher bottoms.
We will use the Momentum Indicator to spot divergence with the price action. However, we will enter trades, only if the price breaks the Moving Average of the Bollinger Bands and the bands are expanding at the same time. This way we will get confirmation for our signals and we will enter trades only during high volatility. We will exit our trades when the price crosses the Moving Average of the Bollinger Bands in the opposite direction.
This is how this strategy works:. At the bottom of the chart you see the Momentum Indicator. On the price chart you see the Bollinger Bands overlay in green.
After a period of price increase, the Momentum Indicator starts recording lower top while price is making higher highs. This is a bearish divergence between the price action and the Momentum Indicator. Then, we see a large bearish candle, which breaks the Moving Average line between the bands. At the same time, the Bollinger Bands start expanding, indicating higher volatility.
The short trade in this case could have been closed out when price breaks the Moving Average of the Bollinger Bands in bullish direction. The proper location of a stop loss order in this trade should be above the last top of the price action prior the price break at the center Bollinger band line.
As you can see the risk was very nominal in relation to the overall profit that could have be realized from this trade.
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We have discussed the types of divergence patterns and some reliable indicators to trade divergence with. Now we know how to spot divergence and how to enter the market on a divergence. However, before you start trading divergence setups, there are a few more points which we need to discuss further.
These things include an example money management approach when trading divergence setups.
Divergence and Convergence
If you do not have a sound money management plan you are likely to lose money trading divergences or any other setups for that matter. Regardless of the trading method you use, you should always use a Stop Loss order for each of your trades. It is no different when you trade divergences. And for most traders, it is best to place a hard stop in the market instead using a mental stop. As far as the divergence setup goes, one way to place your stop loss would be put it right above the last top on the chart, which confirms the bearish divergence.
If the divergence is bullish, then we rely on bottoms and the stop should be placed below the last bottom on the chart. The image below will give you an idea of where to put your stop loss when trading divergence. This created an opportunity to enter the market with a long trade at 0. The stop loss location would be below the swing low, right below the last bottom of the divergence pattern. You should always have strict take profit rules when trading divergence.
For all the positives of trading divergences, one of the things that divergence trading does not offer us, are clear targets. Therefore, an additional tool should be used in order to select your profit targets. Typically, If you trade divergence with RSI or Stochastic, you may need an additional indicator to close your trades.
However, if you use the MACD, then you could fully rely on this indicator alone. The reason for this is that the MACD is a lagging indicator and it is a good standalone tool for exits as well as entries. My preferred method is to use swing analysis and and support resistance levels for trade management and profit target setting, however, as I have just mentioned, the MACD is also a viable option.
When the RSI makes an equal high, it does not qualify as a divergence because it just means that the strength of the uptrend is still up and stable. Higher highs on the RSI do not show a reversal or weakness. It just means that the trend is progressing unchanged. This is what we call a divergence and in the screenshot below, the divergence signaled the end of the uptrend and it makes a downtrend possible.
Classic technical analysis tells us that a trend exists when price makes a higher high — but like too often, conventional wisdom is seldom right and usually simplifies things too much. A trader who only relies on highs and lows for his price analysis often misses important clues and does not fully understand market dynamics. Spotting a divergence on your momentum indicator, thus, tells you that the dynamics in the trend are shifting and that, although it could still look like a real trend, a potential end of the trend could be near.
A divergence does not always lead to a strong reversal and often price just enters a sideways consolidation after a divergence. Keep in mind that a divergence just signals a loss of momentum, but does not necessarily signal a complete trend shift. A divergence alone is not something that strong enough and many traders experience bad results when trading only with divergences.
Just like any trading strategy, you need to add more confluence factors to make your strategy strong. Below we see how price made 2 divergences but price never sold off. The divergences, thus, just highlighted short-term consolidation. Location is a universal concept in trading and regardless of your trading system, adding the filter of location can usually always enhance the quality of your signals and trades. The screenshot below is a great example: On the left side, you see an uptrend with two divergences. However, the first one completely failed and the second one resulted in a massive winner.
What was the difference?
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When we take a look at the higher time frame on the right we see that the first divergences happened in the middle of nowhere and the second divergence formed at a very important resistance level yellow line and yellow arrow. Such an approach will impact your performance in a big way.
Divergences are a powerful trading concept and the trader who understands how to trade divergences in the right market context with the correct signals can create a robust method and effective way of looking at price. Thank You, Rolf! Good article, especially these comments : When we take a look at the higher time frame on the right we see that the first divergences happened in the middle of nowhere and the second divergence formed at a very important resistance level yellow line and yellow arrow.
Very helpful to master the market! To date i have not found a trading strategy with a higher winning percentage than divergence combined with support and resistance levels. Thanks Rolf for this interesting article. Another potential downside is that the MACD is a trend following indicator. This means that the indicator gives its signals as the trend occurs, not before it starts. So, if you are looking to recognise an upcoming trend, the MACD is not the best indicator for this function.
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Types of Divergences
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