Divergence in Forex Trading
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The Forex divergence 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 in Forex occurs when there are no clear directional trends, and traders use the Forex divergence strategy to signal to move forward. Usually, this involves taking positions with both sides of a trade.
Discover what divergence in Forex is, what indicators help detect Forex 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. The trading divergence signal is often 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.
The ratio of Forex traders’ positions can also be called divergence. Divergence is easy to find in any market and trading instrument.
It often depends on the trading timeframe and other technical analyses, such as whether an asset trades 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 or price reversal.
How to Trade Divergence in Forex?
- Analyse the market’s current trend direction using technical analysis.
- In order to spot divergence, find the currency pair’s highs (or lows) and the lows (or highs) of technical indicators.
- You then need to identify the direction in which the trend is moving after you have identified both the direction of the currency pair’s price and the indicator value’s movement.
- Trends following upward movements constitute bearish divergence signals that indicate traders should sell and be short. In contrast, if the trend is following a downward movement, this is a bullish divergence signal, meaning order to buy or sell.
- There is the option to set the stop-loss order at a distance from either the highest high price level or the lowest low price level, away from the current price.
- You can place the take profit order at twice the distance of the stop loss order.
Currency pairs’ price movement diverges from technical indicator movement when it moves in the opposite direction. A weakening price trend may signify that the price is about to change direction, and in some cases, it may result in a price change.
The movement of currency prices and forex indicators is generally expected to be similar if the rates are equal. It is supposedly true that the indicator follows the price’s movement to a higher high, for instance.
The indicator is expected to move in the same direction if the price reaches a lower high. Both higher lows and lower lows can be used in the same way.
There is a possibility of a change shortly if the price and the related indicators do not correspond. An indicator of divergence is calculated by comparing the highs and lows of price with related indicators.
A trader might also consider convergence indicators to establish whether a move is likely to continue. However, the divergences are the more powerful and common Forex convergence and divergence indicators. Differing types of divergences include:
Bullish divergence trading
When the direction of movement changes from a downwards to an upwards movement, Forex traders use regular bullish divergence. 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, suggesting that the lower move loses strength and momentum, causing a possible higher move.
Regular Bullish Divergence
A regular bullish divergence occurs when the price makes lower lows on a chart while the indicator makes higher lows.
Price is expected to reverse its downward move and move swiftly upward from this divergence pattern.
Trading Divergence like this is sometimes referred to as classic bullish divergence by traders of financial markets.
Hidden bullish Divergence
Hidden bullish divergence is an indicator that displays lower bottoms while the price has higher bottoms. It occurs when the price is in the midst of an upward trend.
This is sometimes referred to as a positive reverse divergence.
- Bearish divergence trading
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.
Regular Bearish Divergence
Regular divergence is also sometimes referred to as negative divergence.
A regular bearish divergence occurs when a price’s new high is higher than its previous high, and the indicator’s new high is lower than its previous high.
Whenever the price exhibits a regular bearish divergence, it signals that it is expected to cancel its upward trend and move downward.
Hidden bearish Divergence
An indicator that indicates higher tops while the price shows lower tops confirms a hidden bearish divergence. There is a downtrend occurring, and it should continue downward.
Also known as negative reverse divergence.
- Bullish hidden divergence, or extended divergence
Divergences used for trading the continuation of a trend are called hidden divergence or extended divergences and work differently than bullish and bearish divergences.
It can also be of two forms i.e., extended bullish divergence and extended bearish divergence.
Technical divergence, or extended bullish divergence, is when the price cycles make a higher low while the technical indicator makes a lower low.
By definition, the indicator is lower while prices are higher, 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.
- Bearish hidden or extended 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.
Difference between a regular divergence and hidden divergence forex trading
There is a simple difference between regular and hidden divergence. Regular divergences signal the reversal of trending price action, while hidden divergences indicate that price will move in the same direction, upwards or downwards.
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 Forex 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.
How to trade regular divergence?
When a price makes lower lows, the oscillator posts higher lows, it’s called a regular bullish divergence. There is a possibility that a trend reversal could follow, and recovery might occur.
Regular bearish divergences can be detected when the price is making a higher high, but the oscillator is making a lower high. It could signify that the current uptrend has run out of momentum and that a retracement will occur.
How to trade hidden divergence?
Divergence can also signal a potential continuation of a trend. Let’s examine hidden divergences.
The hidden bullish divergence occurs when the price and the indicator make higher lows during an uptrend. This could indicate that the upward trend will continue.
In contrast, hidden bearish divergences appear when prices make lower highs in a downtrend, while oscillators make higher highs. A resumption of the downtrend might be imminent.
An RSI divergence
All indicators work with divergences, but the RSI (Relative Strength Index) is the most popular. A Relative Strength Index 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 ones over the past 14.
Relative Strength Index values below zero reflect a more significant number and strength of bearish candles than bullish ones over the past 14.
Conversely, RSI values above zero reflect a more significant number and size of bullish candles over the past 14 periods.
When does an RSI form?
To correctly interpret divergence trading strategy, 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:
- It 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 indicator, higher highs do not indicate weakness or a reversal. Instead, they indicate the trend continuation.
- 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 Forex 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 technical indicators using divergence?
You can use any oscillator indicator to find divergence. The results will vary depending on the trading currencies and other indicators used.
Among all the technical indicators available, we have selected three that can be extremely helpful.
- MACD indicator
Currency MACD indicators can be beneficial for identifying divergences and identifying early trend reversals.
You can use the MACD indicator on any timeframe with its default settings. However, it is best to use 1-hour timeframes. Alternatively, you can use the support and resistance levels or take profit and stop-loss levels at fixed 20 pips.
- Commodity channel index
A leading 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 an indicator 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 this in mind! When trading Forex divergences, 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 and price highs are simultaneously 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 forex 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 divergences.
Mistake no 8
Divergence is also often mistaken for reversal signals. However, depending on the type, this divergence may indicate either a trend reversal or trend continuation.
Top tips for Trading Divergence
Divergence is an easy tool to use. Although it has many features, you should never forget to use them correctly:
- Any timeframe can show divergence.
- It is possible to use divergence for any asset.
- Oscillators are typically the indicators that form divergence on price charts.
- A signal can be a bullish divergence or bearish divergence.
- The regular bearish divergence and the hidden bearish divergence both occur at highs. When looking for regular and hidden bullish divergences, it’s vice versa. Then you would look at the lows.
- There is a high probability of a market reversal when divergence occurs regularly. The previous price movement will continue after the hidden divergence is removed.
- It is impossible to determine a perfect entry/exit point using divergence. It can, however, provide necessary information about the future direction of prices.
What does Forex divergence tell you?
The fundamental approach to finding divergence in Foreign exchange 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 posts lower highs. If this does not happen, the price and oscillator are diverging.
One of the most common questions traders ask is: How accurate is divergence trading? Answering this question requires an understanding that technical tools are not predictive.
Statistical probabilities indicate what is more likely to happen than what is less likely. It is, therefore, possible to determine the probability of an event occurring by combining tools and analysis.
Risk management is a hallmark of any Forex divergence trading strategy since traders deal with probabilities and will take losing trades to try and win.
Should You Use Divergence in Forex Trading?
Divergence is a market condition in which prices and indicators move in opposing directions.
The upcoming market movement can be predicted based on divergence regarding the locations of highs and lows. Leading indicators include MACD, RSI, and Stochastic Oscillator.
A divergence indicator is a simple tool that newcomers and professionals can easily use. If you have never used hidden divergence, you might find it challenging.
Opening a demo trading account may be a good idea if you lack experience. Getting experience in a safe environment is the best way to learn how to trade Forex and live without risk.
Divergence strategies can be applied to trading CFDs and any other complex instruments.
You’ll be able to open retail investor accounts after depositing your initial investment once you gain the necessary skills for using financial instruments.
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 signal while the indicator indicates a downward trend. Or the indicator is rising while the price trend is falling.
How do you use divergence in Forex 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 for hidden and extended divergence.
They indicate the trend continuation, unlike regular divergences. As a result, traders can use them to filter false signals and trade with the trading signal.
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.
Forex 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 several types of divergences: regular bearish divergence/regular bullish divergence, hidden bearish divergence/hidden bullish divergence, and extended bullish divergence/extended bearish divergence.
Any oscillator can serve to find divergence, including MACD, CCI, and Stochastics. Using confirmatory signals will increase the likelihood that your Forex trading is successful.
Even if divergence does not play a role in your Forex trading strategy, you may want to watch it, as it can be another confirmation signal. Divergence in Forex trading works best as a part of your overall trading strategy instead of as a standalone indicator.
Jason Morgan is an experienced forex analyst and writer with a deep understanding of the financial markets. With over 13+ years of industry experience, he has honed his skills in analyzing and forecasting currency movements, providing valuable insights to traders and investors.
Forex Content Writer | Market Analyst