Divergence Trading Strategies
Last Update: July 15th, 2019
Apart from fundamentals, traders and analysts of financial instruments use a number of indicators to figure out what might happen to the price of a certain instrument. These indicators offer a simple method of recognizing patterns and predicting which way the price will trend.
In essence, these indicators are what makes Forex signals possible. They allow for a comprehensive real-time analysis of price action and the team here at FX Leaders implements them on a day-to-day basis.
What Is Divergence?
Divergence is a leading indicator utilized by our analysts at FX Leaders to help significantly increase profits. The likelihood of entering the market at the right time in the right direction increases if used in conjunction with other indicators such as Moving Averages (MA), RSI, Stochastics, or various support and resistance levels.
What Is Divergence Trading?
By merely acknowledging the name “divergence,” one can easily tell that divergence trading is a type of trading rooted in disharmony or deviation. Divergence forex trading strategies are frequently applied by currency traders around the globe.
In theory, prices and indicators are supposed to go in the same direction at equal rates. If price reaches a higher high, then the indicator is supposed to reach a higher high. If price reaches a lower high then the indicator is supposed to follow suit. The same applies to lower lows and higher lows.
If the price and the associated indicators don’t correlate, then you can tell that some kind of change is about to take place. In short, divergence is calculated between highs and lows of price and the indicators. The best indicators to use in divergence trading are Stochastics, RSI, MACD, and Trade Volume.
A bullish divergence occurs when the change of the indicator is more positive than the change of the price — bearish divergence is the other way around. Applying this distinction, there are four basic types of divergence:
- Regular Bullish
- Hidden Bullish
- Regular Bearish
- Hidden Bearish
We will explain each type and how to trade the corresponding divergence forex strategy.
Regular divergences are used as a tool to indicate reversals. This EUR/USD monthly chart shows the price making a lower low during a two-day period. But the momentum in MACD and Stochastics didn’t correspond to that of the price action, making higher lows. This signals a possible reversal of the trend or at least a retrace of the downtrend.
Adding to this is the fact that the price was trading between 1.035 and 1.0450 for about two years, which means that the sellers couldn’t push it any lower for a very long time. Taking a long from around that level would give a good risk/return ratio.
Regular Bullish Divergence – price is making lower lows while indicators are making higher lows. This indicates a coming reversal or retrace.
As we can see from the 4-hour chart, the price reached a high in the previous week and then made a higher high the following week. On the other hand, the MACD indicator at the bottom of the chart is making lower highs. This is called ‘Regular Bearish Divergence’ and indicates a fall in the price to come.
In this case, since we are in an uptrend, we should expect a retracement. After entering at the top, we should look to get out of the trade at the uptrend line.
Regular Bearish Divergence – The price is making higher highs while MACD is making lower highs.
Unlike regular divergence, hidden divergence indicates a continuation of the trend. This GBP/USD weekly chart shows several occasions where the price was making higher lows, while the stochastic was making lower lows. This divergence indicates that the retrace down is over and trend continuation is about to resume.
Hidden Bullish Divergence – unlike regular divergence, hidden divergence indicates the continuation of the trend.
The daily EUR/USD chart below gives a clear example of hidden divergence and the trend reversal that follows. We can see that when stochastic was nearing overbought levels and had established divergence with the price which made lower highs, the pair fell immediately and began a downtrend. This sort of chart pattern means that when the stochastic was overbought the second time, EUR/USD buyers couldn’t push any higher. So, the upside was complete even though EUR/USD couldn’t make new highs. This is a bearish reversing signal.
Hidden Bearish Divergence – when Stochastics are nearing overbought levels the pair falls immediately to continue the downtrend.
When Using Divergence Forex Strategies…
Divergence is quite easy to spot, as it only requires drawing a few lines. Nonetheless, sometimes we look too hard at the charts. This makes us see things that aren’t really there.
During periods of consolidation or low liquidity, small divergences between price and indicators might form — but that doesn’t mean we should consider them real divergences. The chart below shows a four-day consolidation period with indicators and the price not correlating exactly. However, this setup does not constitute a divergence.
In consolidation periods not everything that looks like divergence is actually divergence — be careful.
Divergence is one of the best ways to use indicators to analyze charts. Alongside other support and resistance strategies, the divergence forex trading can be used to give your analytical skills the push they need to make you a very profitable trader. If you want to get a feel for how divergence trading is used in live market situations, take a look at our weekly analysis from April 17-23. In our weekly analysis, our top Forex experts explain how they use divergence trading, alongside other Forex strategies to analyze the market’s actions every day.