DIVERGENCE IN FOREX
Understanding the concept of divergence in forex
The concept of divergence plays an important role in technical analysis. In the forex market, divergence occurs when the price action forms a new high/low but the oscillator does not. This divergence in price and momentum signals a potential trend reversal. There are two main types of divergence:
- Hidden divergence: Momentum moves in the opposite direction of price but stays above/below zero. It appears less obvious on charts.
- Regular divergence: Momentum forms a new high/low while price makes a lower/higher high/low. This divergence is easier to spot on charts.
Identifying divergence in forex charts
There are a few key things traders look for when identifying divergence on forex charts:
- Timeframe: Divergences are most reliable on higher timeframes like daily and weekly charts. Lower timeframes are noisier.
- Oscillators: Common ones used are RSI, stochastic, and MACD. Divergences spotted between price action and these momentum indicators can signal weakening trends.
- To compare peaks and troughs in oscillators, the peak or trough must be higher for regular divergence. It must fail to make a new high for hidden divergence against the corresponding price swing.
- Price confirmation: Wait for price to change direction, confirming the divergence. Single red/green candlesticks aren’t enough.
- Retest levels: Price reversing after a retest of the broken swing high/low adds strength to the divergence signal.
- Volume analysis: Higher volume on the price reversal confirms loss of momentum hinted at by the divergence.
- Spotting valid divergences takes practice but can provide insight into market behavior changes.
Explaining how divergence can say potential price reversals
Divergence occurs when momentum shows weakness despite rising prices. It also happens when momentum shows strength despite falling prices. This implies a disagreement between price and momentum that is not sustainable. When momentum leads price, it signals demand or selling pressure may be weakening even as the price is still rising/falling. This raises the probability of a trend reversal. The wider the divergence, the more significant it is as an early warning sign.
Discussing the significance of divergence in forex trading
Identifying divergence is important. It can provide traders with high probability reversal signals. Traders spot divergence and are alerted to potential trend changes before price confirms them. This allows entries closer to reversal areas for optimal risk/reward. Divergence also indicates where support/resistance may be overcome. Not all divergences lead to reversals. But, incorporating them into analysis can help filter trades and spot significant trend changes. Other indicators and price action use them alongside.
Definitions of divergence in forex
Divergence in forex is a situation where the price of a currency pair and an indicator move in opposite directions. It indicates a possible reversal or weakening of the current trend. There are two types of divergence: regular and hidden. Regular divergence occurs when the price makes a higher high or a lower low, but the indicator does not. Hidden divergence occurs when the price makes a lower high or a higher low, but the indicator does not.
Common terminology associated with divergence in forex trading:
Forex traders use the following terms to describe divergence in forex trading:
An oscillator is a technical indicator that moves between two extreme values, such as RSI, MACD, and Stochastic. It measures the momentum and strength of the price movement.
- Trend line: A trend line is a line that connects two or more significant highs or lows on the price chart. We use trend lines to identify the direction and slope of the trend.
- Swing high: A swing high is a peak or a local greatest on the price chart. It is usually formed when the price reverses after an uptrend.
- Swing low: A swing low is a trough or a local least on the price chart. It is usually formed when the price reverses after a downtrend.
- Bullish divergence: A bullish divergence is a situation where the price makes a lower low, but the oscillator makes a higher low. It signals a potential upward reversal or a continuation of the uptrend.
- Bearish divergence: A bearish divergence is a situation where the price makes a higher high, but the oscillator makes a lower high. It signals a potential downward reversal or a continuation of the downtrend.
Recognized experts’ insights on identifying divergence
Divergence occurs when the price and an indicator move in opposite directions. It indicates a possible trend reversal or continuation. Some recognized experts who have shared their insights on identifying divergence are:
– Oddmund Groette is the founder of Quantified Strategies. The website provides quantitative analysis and trading strategies. He has written a comprehensive article on divergence trading strategy. In the article, he explains the types of divergence, the indicators to use, and the backtest results of a divergence strategy.
– Dr. Pipslow: He is a fictional character created by BabyPips.com, a popular forex education website. He is a trading psychologist who teaches traders how to deal with the emotional aspects of trading. He has written a blog post on the nine rules for trading divergences, where he gives practical tips on how to spot and trade divergence signals.
– Eightify: It is an app that provides summaries of trading strategies, books, and podcasts. It has a summary of effective divergence trading strategies for profit. It explains the concept of divergence, the types of divergence, and the rules to enhance your trades.
Expert views on trading strategies based on divergence
Trading strategies based on divergence aim to exploit the potential reversal or continuation of the price trend. This happens when the price diverges from an indicator. Some expert views on trading strategies based on divergence are:
– Trading Strategy Guides: It is a website that offers trading education, indicators, and systems. It has an article on the divergence trading strategy. It explains five rules to enhance your trades. It includes using trend lines, waiting for confirmation, and using many time frames.
– Investopedia: It is a leading source of financial information and education. It has an article on how to trade indicator divergence. The article explains the advantages and disadvantages of divergence trading. It also covers the types of indicators to use and provides examples of divergence trading setups.
– Forex Academy: It is a website that provides forex trading courses, signals, and analysis. It has a video on how to trade divergence like a pro. The video explains the logic behind divergence trading. It discusses the best indicators to use and provides live examples of divergence trading entries and exits.
TYPES OF DIVERGENCE IN FOREX
Regular Divergence
When an asset’s price makes a lower low, while using an indicator like RSI or MACD, it creates a regular bullish divergence. This indicates that the selling pressure is weakening and that a trend reversal from bearish to bullish is likely. To identify a regular bullish divergence, you need to look for the following conditions:
- The price is in a downtrend and makes a new low.
- The indicator fails to make a new low and forms a higher low instead.
- The indicator and the price show a divergence, meaning they move in opposite directions.
A break of a trend line or a reversal candlestick pattern on the price chart confirms the divergence.
You can recognize regular divergence on forex charts by comparing the price action with the indicator or oscillator. If the price forms a higher high but the indicator forms a lower high, it indicates bearish regular divergence. If the price forms a lower low but the indicator forms a higher low, it indicates bullish regular divergence. The chart below shows an example of regular divergence on the EUR/USD 4-hour chart. The price makes a higher high, but the MACD makes a lower high, signaling a bearish regular divergence. A break of the trend line and a bearish engulfing candlestick pattern confirm the divergence. The price then reverses and falls.
Hidden Divergence
When the price of an asset makes a higher low (HL), while the indicator (like RSI or MACD) makes a lower low (LL), it indicates a hidden bullish divergence. This indicates that the buying pressure is strong and that a trend continuation from bullish to more bullish is likely. To identify a hidden bullish divergence, you need to look for the following conditions:
- The price is in an uptrend and makes a new high.
- The indicator fails to make a new high and forms a lower high instead.
- The indicator and the price show a divergence, meaning they move in opposite directions.
A break of a resistance or a bullish candlestick pattern on the price chart confirms the divergence.
You can recognize hidden divergence on forex charts by comparing the price action with the indicator or oscillator. If the price forms a lower low but the indicator forms a higher low, it indicates bearish hidden divergence. If the price forms a higher low but the indicator forms a lower low, it indicates bullish hidden divergence.
The chart below shows an example of hidden divergence on the GBP/USD 1-hour chart. The price makes a higher low, but the RSI makes a lower low, signaling a bullish hidden divergence. A break of the resistance and a bullish engulfing candlestick pattern confirm the divergence. The price then resumes its uptrend and reaches a new high.
Complex Divergence Patterns
Understanding complex divergence patterns in forex
Complex divergence patterns are situations where there are more than two consecutive highs or lows on both the price and the indicator, forming a complex wave structure. These patterns indicate that the market is in a strong trend, but there is a possibility of a reversal or a correction. There are two types of complex divergence patterns: complex bullish divergence and complex bearish divergence.
Complex bullish divergence occurs when the price makes a series of lower lows, while the indicator makes a series of higher lows. This shows that the downtrend is losing momentum and the buyers are gaining strength. A complex bullish divergence can signal a trend reversal from bearish to bullish, or a trend continuation after a pullback.
Complex bearish divergence occurs when the price makes a series of higher highs, while the indicator makes a series of lower highs. This shows that the uptrend is losing momentum and the sellers are gaining strength. A complex bearish divergence can signal a trend reversal from bullish to bearish, or a trend continuation after a retracement.
Trading strategies for complex divergence patterns
Trading complex divergence patterns requires patience and discipline, as they can take a long time to develop and confirm. Here are some general guidelines for trading complex divergence patterns:
– Wait for the price to break the trend line that connects the highs or lows of the price and the indicator. This confirms the divergence and indicates a possible change in trend direction or strength.
– Use other technical tools. These include support and resistance levels, Fibonacci retracements, and candlestick patterns. They help identify potential entry and exit points. For example, you can enter a long trade after a complex bullish divergence. This happens when the price breaks above a resistance level or forms a bullish reversal candlestick pattern. You can exit the trade when the price reaches a Fibonacci extension level or forms a bearish reversal candlestick pattern.
– Use a stop loss to protect your trade from unexpected price movements. For a long trade, place your stop loss below the lowest low of the price or the indicator. For a short trade, place it above the highest high of the price or the indicator.
– Use a risk-reward ratio of at least 1:2 to ensure that your potential profit is larger than your potential loss. You can adjust your position size and target price.
Recognizing complex divergence signals
Recognizing complex divergence signals can be challenging. They are not as clear and obvious as regular or hidden divergence signals. But, there are some tips and tricks that can help you spot complex divergence signals more:
– Use a higher time frame, such as the daily or weekly chart, to filter out the noise and focus on the major trend. Complex divergence patterns are more reliable and significant on higher time frames than on lower time frames.
– Use a sensitive indicator, such as the MACD or the Stochastic, to capture the subtle changes in momentum and divergence. These indicators can show complex divergence signals earlier and more than less sensitive ones. Examples of less sensitive indicators include the RSI and the CCI.
– Use many indicators, such as the MACD and the Stochastic, to confirm the complex divergence signals. If two or more indicators show the same complex divergence signal, it increases the probability and validity of the signal.
Complex Divergence Patterns
Understanding complex divergence patterns in forex
Complex divergence patterns happen when there are more than two consecutive highs or lows on both the price and the indicator. This forms a complex wave structure. These patterns say that the market is in a strong trend, but there is a possibility of a reversal or a correction. There are two types of complex divergence patterns. They are complex bullish divergence and complex bearish divergence.
– Complex bullish divergence occurs when the price makes a series of lower lows, while the indicator makes a series of higher lows. This shows that the downtrend is losing momentum and the buyers are gaining strength. A complex bullish divergence can signal a trend reversal from bearish to bullish, or a trend continuation after a pullback.
– Complex bearish divergence occurs when the price makes a series of higher highs, while the indicator makes a series of lower highs. This shows that the uptrend is losing momentum and the sellers are gaining strength. A complex bearish divergence can signal a trend reversal from bullish to bearish, or a trend continuation after a retracement.
Trading strategies for complex divergence patterns
Explanation of popular divergence indicators:
Divergence indicators are technical tools. They compare the price movement of an asset with an oscillator. For example, the Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD). This helps identify discrepancies between the two. These discrepancies, or divergences, can say potential trend reversals or changes in momentum. Some of the most popular divergence indicators are:
The RSI Divergence Indicator bases its measurements on the classic RSI. The classic RSI measures the strength and direction of the price movement. The RSI divergence indicator plots circles and arrows on the chart to show the divergence between the price and the RSI. A bullish divergence occurs when the price makes a lower low but the RSI makes a higher low. A bearish divergence occurs when the price makes a higher high but the RSI makes a lower high.
The MACD Divergence Indicator uses the MACD as its basis. Two moving averages compose the MACD, which shows the trend and momentum of the price. The MACD divergence indicator plots lines and histograms on the chart to show the divergence between the price and the MACD. A bullish divergence occurs when the price makes a lower low but the MACD makes a higher low. A bearish divergence occurs when the price makes a higher high but the MACD makes a lower high.
The stochastic serves as the basis for the Stochastic Divergence Indicator. The stochastic is a range-bound oscillator. It shows the overbought and oversold conditions of the price. The stochastic divergence indicator plots dots and arrows on the chart. It shows the divergence between the price and the stochastic. A bullish divergence occurs when the price makes a lower low but the stochastic makes a higher low. A bearish divergence occurs when the price makes a higher high but the stochastic makes a lower high.
How to use divergence indicators effectively
Divergence indicators can provide valuable signals. They help traders expect trend reversals or changes in momentum. Traders should use divergence indicators with caution and confirmation. They are not infallible. Here are some tips on how to use divergence indicators:
– Use a higher time frame to filter out the noise and focus on the major trend. Divergence indicators are more reliable and significant on higher time frames than on lower time frames.
– Use many indicators to confirm the divergence signals. If two or more indicators show the same divergence signal, it increases the probability and validity of the signal.
Use other technical tools, such as support and resistance levels, trend lines, or candlestick patterns. These tools can help you identify potential entry and exit points. For example, you can enter a long trade after a bullish divergence when the price breaks above a resistance level. Or, when it forms a bullish reversal candlestick pattern. You can exit the trade when the price reaches a target level or forms a bearish reversal candlestick pattern.
– Use a stop loss to protect your trade from unexpected price movements. For a long trade, you can place your stop loss below the lowest low of the price or the indicator. For a short trade, you can place your stop loss above the highest high of the price or the indicator.
– Use a risk-reward ratio of at least 1:2 to ensure that your potential profit is larger than your potential loss. You can adjust your position size and target price.
CONCLUSION
Key Takeaway
- Divergence is a powerful concept in forex trading. It can help traders identify potential trend reversals or continuations.
- Divergence indicators, like RSI, MACD, and Stochastic, compare price movement with momentum. They can spot discrepancies between the two.
- There are different types of divergence patterns. These include regular, hidden, and complex divergences. Each type requires different trading strategies and confirmation tools.
- Divergence trading can improve trading performance and profitability. This requires patience and discipline.
FAQs
1. What is the difference between regular and hidden divergence?
Regular divergence occurs when the price makes a higher high or a lower low, but the indicator does not. It signals a possible trend reversal. Hidden divergence occurs when the price makes a lower high or a higher low, but the indicator does not. It signals a possible trend continuation.
2. What are the best indicators for divergence trading?
There is no definitive answer to this question. Different indicators may suit different trading styles and preferences. Some of the most popular indicators for divergence trading are RSI, MACD, and Stochastic. They are sensitive and reliable in showing the momentum and divergence.
3. How can I confirm a divergence signal?
A divergence signal alone is not enough to enter a trade, as it may be false or premature. It’s best to use other technical tools to confirm the divergence signal. For example, support and resistance levels, trend lines, Fibonacci retracements, or candlestick patterns. Doing so will help you identify the optimal entry and exit points.
