The divergence forex occurs when a currency pair’s price moves in one direction, but the trend indicator moves in the opposite direction. Both positive and negative signals can occur with divergence.
Divergence occurs when there are no clear directional trends, and traders use divergence as a signal to move forward. Usually, this involves taking positions with both sides of a trade.
Discover what divergence is, what indicators help detect divergence, and how Forex traders use it to make money.
What is divergence in Forex?
When Forex divergence occurs, an asset moves in the opposite direction to a technical indicator. Most often, the indicator is a momentum oscillator or relative strength indicator. Divergence appears in Forex trading as a sign that the current price direction is losing momentum, which would lead to a change in direction.
It often depends on the trading timeframe and other technical analyses, such as whether an asset is trading around a historic level of support or resistance. The change in direction is a simple retracement or a sign of a more significant trend reversal.
A trader might also consider convergence indicators to establish whether a move is likely to continue. The divergences, however, are the more powerful and more common Forex convergence and divergence indicators. Differing types of divergences include:
1. Bullish divergence
When the direction of movement changes from a downwards to an upwards movement, traders use bullish divergences. For example, a price cycle creates a lower low during such cycles, while a technical indicator creates a higher low. Essentially, the indicator does not follow the price down, suggesting that the move lower loses strength and momentum, causing a possible higher move.
2. Bearish divergence
Traders use divergences to trade the change from upward to downwards price movement. When a price cycle establishes a higher high and, at the same time, a technical indicator establishes a lower high, these patterns occur. Essentially, the indicator is not tracing the price up, which indicates that the move higher is weakening and losing momentum, resulting in a move lower.
3. Bullish hidden, or continuation, divergence
Divergences used for trading the continuation of a trend are called hidden or continuation divergences and work differently than bullish and bearish divergences. Technical divergence, or continuation divergence, is when the price cycles make a higher low while the technical indicator makes a lower low.
By definition, while prices are higher than before, the indicator is lower, suggesting the market has severely oversold conditions. These elements can potentially attract buyers interested in trend-following trading strategies in an uptrend, such as buying low and selling high.
4. Bearish hidden, or continuation, divergence
The divergence between a technical indicator and the price cycle occurs when the technical indicator makes a higher high while the price cycle makes a lower high in bearish divergence.
The indicator suggests that the market has a much higher overbuying despite the lower price. In a downtrend, those who seek traditional strategies such as trend following and ‘sell high, buy low’ might be attracted to this feature.
Making a winning divergence trade
How can we minimise the risks associated with a divergence trade while maximising its potential profit? As a first step, long-term charts (daily or higher) provide better signals than shorter-term ones (short-term or daily).
Once you’ve found a high-probability trading opportunity, you can use fractionally sized trades on oscillator divergence to enter a position. Using this method, you can avoid making a significant commitment if the divergence signals immediately become false. Even if a false signal occurs, stop-loss levels should be adjusted firmly – not so tight that whipsaws take you out, but not so loose that the benefit-risk ratio skews.
In contrast, you may gradually increase your trade size until your intended size becomes favourable if the trade becomes favourable. It is advisable to hold the position until momentum slows or a significant pullback occurs when momentum continues beyond that. Once the momentum starts to fade, you take progressive profits on your fractional trades to exit the position.
When choppy, directionless markets persist, as we have seen with the second divergence signal mentioned above on USD/JPY, it should prompt you to cut your risk and look for a better divergence trade.
An RSI divergence
All indicators work with divergences, but the RSI (Relative Strength Index) is the most popular. An RSI calculates the difference between an average gain and an average loss over a certain period. Thus, for example, if the RSI equals 14, it compares the bullish candles with the bearish candles over the past 14 candles.
RSI values below zero reflect a more significant number and strength of bearish candles than bullish candles over the past 14 candles. Conversely, RSI values above zero reflect a more significant number and size of bullish candles over the past 14 periods.
When does an RSI divergence form?
To correctly interpret divergences, traders should understand when their indicator is high or low, and they must look beyond the squiggly lines of their indicator to see what it does.
The RSI can be used during trends to assess the trend’s strength by comparing waves in the trend. These are the three scenarios:
- The RSI tends to make higher highs during strong and healthy bullish trends. As a result, more and larger bullish candles formed in the most recent trend wave than in the previous trend wave.
- An RSI making similar highs signifies that the momentum of an uptrend remains unchanged. If the RSI makes the same high, it does not constitute a divergence since it simply means that the uptrend strength is still positive and stable. In the RSI, higher highs do not indicate weakness or a reversal. Instead, they indicate the trend is continuing.
- Following a bullish trend, if the price makes a higher high, but your RSI makes a lower high, the most recent bullish candles did not have the same strength as previous ones, leading to a trend losing momentum. With the divergence, the uptrend ended, and the downtrend became possible.
Conventional technical analysis is flawed
According to conventional wisdom, a trend exists when the price makes a higher high – but this conventional wisdom is rarely correct and typically simplifies things too much. As a result, the trader who only looks at highs and lows when analysing price often misses important clues and doesn’t understand market dynamics.
At first glance, a trend may be “healthy” (higher highs and higher lows), but it could be losing momentum when we dig deeper into the candles and the momentum. Consequently, spotting a divergence in your momentum indicator indicates that the dynamics in the trend are changing, especially if the trend still seems to be accurate. Still, the trend may be approaching its end.
What are the best indicators using divergence?
You can use any oscillator indicator to find divergence. Depending on the currencies and indicators used, the results will vary. Among all the oscillator indicators available, we have selected three that can be extremely helpful.
1. MACD indicator
Currency MACD indicators can be beneficial for identifying divergences and identifying early trend reversals.
You can use the indicator on any timeframe with its default settings. However, it is best to use 1-hour timeframes. As an alternative, you can use the support and resistance levels or take profit and stop-loss levels at fixed 20 pips.
2. Commodity channel index
A good indicator to determine divergence is the CCI indicator. You can apply its default settings to any time frame. However, it is advisable to use timeframes of 15 minutes, 30 minutes, and one hour to be safe. Trading can end using oversold and overbought conditions.
The stochastic indicator helps detect divergence. With this indicator, you can exit the trades in overbought and oversold conditions. The recommended timeframe is 1 hour.
Common mistakes when trading with divergences
It is common for new traders to find inaccurate information on the Internet about divergences. Let’s look at the most common mistakes everyone makes when trading divergences:
Mistake no 1
On many Forex trading websites, it appears that divergence exists. Based on their assumptions, if an indicator moves upward, the line drawn across the indicator peaks shows natural highs. On this basis, they draw a line connecting the highs on the price chart.
The indicator highs on the downtrend correspond to the price lows on the chart when the indicator highs fall below the zero line. If the indicator falls, the lows need to be connected; the highs need to be connected if it increases.
Keep in mind! Whenever you are trading divergences, always start by looking at the price chart. First, you need to determine the price extremes in the chart, ideally, a double top or double bottom. Then, once you identify the divergence, you can identify the price extremes.
Mistake no 2
Traders make another common mistake by simply connecting adjacent peaks of the indicator bars to identify divergence. However, they fail to consider whether the peaks appear within the same trend during this process.
A must-do! The only way to spot fundamental divergences is to compare only the extremes within a similar trend.
Mistake no 3
Traders can also consider price and indicator charts as false divergences when an upward slope appears on the indicator chart, but a downward slope is visible on the price chart. The mistake is obvious!
Take note! The divergence between the price and the indicator is determined by the divergence/convergence of their highs and lows rather than by the direction of their lines.
Mistake no 4
Traders often mistake analysing the divergence between price highs and indicator lows.
Mistake no 5
Be sure the indicator highs and the price highs are at the same time when you notice a divergence. If they appear at different times, you should not analyse them!
Mistake no 6
Due to its early nature, divergence presents quite a few false signals. So don’t rely solely on divergences for trading!
Mistake no 7
Take into account only the price movement that follows the divergence. This implies that the signal was false. Of course, it would help if you did not trade previous divergences.
Mistake no 8
Divergence is also often mistaken for reversal signals. However, this divergence may indicate either a trend reversal or continuation depending on the type.
What does Forex divergence tell you?
The fundamental approach to finding divergence in Forex is to compare price movement with an indicator (usually an oscillator).
Generally, the oscillator should follow the price by making higher highs if the price reaches higher highs. Additionally, it should follow suit if the oscillator also makes lower lows when the price is posting lower highs. If this does not happen, the price and oscillator are diverging.
- What is divergence in Forex trading?
An indicator’s deviation from the price chart defines the divergence between the two. In other words, the price chart indicates an upward trend while the indicator indicates a downward trend. Or the indicator is rising while the price trend is falling.
- How do you use divergence in trading?
In most cases, regular divergence can predict an upcoming reversal in price. When the trend is at its peak or bottom, entering a trade is a good time. It is also an excellent time to look out for hidden and extended divergences.
They indicate the continuation of the trend, unlike regular divergences. As a result, traders can use them to filter false signals and trade with trends.
- Is trading divergence profitable?
In trading strategies, divergence signals are the basis for decision making. In addition, these signals may also serve as part of a filter used to check the reliability of signals. Therefore, it is impossible to ignore their importance when knowing and working with divergence signals.
Trading with these skills at least protects the deposit and helps traders avoid significant mistakes.
Divergence is a tool for spotting early reversal signals in a trend. There are three types of divergences: regular, extended, and hidden divergences. Any oscillator can serve to find divergence, including MACD, CCI, and Stochastics. Using confirmatory signals will increase the likelihood of your trading being successful.
Even if divergence does not play a role in your trading strategy, you may want to watch it as it can be another confirmation signal. Divergences work best as a part of your overall trading strategy instead of as a standalone indicator.
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