Thanks to the Internet, tens of thousands of individual traders and investors all over the world are discovering the excitement and challenges of online trading in the Forex market. Yet, in contrast to the stock market, the Forex market somehow remains more elusive and seemingly complicated to newcomers. Sometimes one believes that a currency pair will continue to fall, but would like to go short at a better price or a less risky entry. This is wise, and there is a way to do so: It’s called “divergence trading”.
Divergence is when the price of an asset is moving in the opposite direction of a technical indicator, such as an oscillator, or is moving contrary to other data. Divergence warns that the current price trend may be weakening, and in some cases may lead to the price changing direction. There is a positive and negative divergence. Positive divergence indicates that a move higher in the price of the asset is possible. In other words, it signals that the price could start moving higher soon. This happens when the price is moving lower, but a technical indicator is moving higher or showing bullish signals. In contrast,
negative divergence points to lower prices in the future. It occurs when the price is moving higher but a technical indicator is moving lower or showing bearish signals. Negative divergence signals that a move lower in the asset is possible.
Divergence is also classified as regular (classic) and hidden. A regular divergence is used as a possible sign for a trend reversal. If the price is making lower lows (LL), but the oscillator is making higher lows
(HL), this is considered regular bullish divergence.
If the price is making a higher high (HH), but the oscillator is lower high (LH), then you have regular bearish divergence.
On the other hand, A hidden divergence is used as a possible sign for a trend continuation. If the price is making a higher low (HL), but the oscillator is making a lower low (LL), this is considered a hidden bullish divergence.
If the price is making a lower high (LH), but the oscillator is making a higher high (HH), then you have hidden bearish divergence.
With having these basics in mind, as well as the facts that knowing divergence isn’t to be relied on exclusively, as it doesn’t provide timely trade signals, and that it is not present for all major price reversals; here are some tips on how to trade divergences:
If you are having regular divergence where the price is showing higher high, but the oscillator showing a lower high, it’s time to SELL.
On a regular divergence and a lower low price with a higher low oscillator, it is advisable to BUY.
However, on a hidden divergence, when the price points out a higher low contrasting the lower low oscillator, it is also a good chance to BUY.
And finally, when you have hidden divergence with a lower high price and higher high oscillator, try to SELL.
Since we discussed the four types of divergence patterns, we will now talk about the importance of the divergence indicator. As mentioned earlier, you need an indicator on your chart in order to discover divergence. The reason for this is that the price has to be in divergence with something. It is simply impossible to trade divergence without having an extra indicator on the chart. So the question becomes, which indicator or indicators are best for divergence trading? Some reliable indicators for trading Forex divergence are:
MACD, RSI, Stochastic Oscillator, Momentum, and Bollinger Bands
It is worth mentioning that a sound money management plan is required for trading Forex divergence or any strategy for that matter. Divergence Signals do not provide clear Profit Targets. We do not know
how far prices are likely to go once they reverse, so in many cases, we have to utilize other techniques to exit our divergence trade setups.
Please keep in mind that divergence is used as an indicator, not a signal to enter a trade. It wouldn’t be smart to trade basely solely on divergences as too many false signals are given. It’s not 100% foolproof, but when used as a setup condition and combined with additional confirmation tools, your trades have a high probability of winning with relatively low risk.