What is Divergence Trading in Forex?
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A divergence occurs if the trend indicator moves in one direction while the currency pair’s price moves in the opposite direction. Both positive and negative signals can result from divergence.
Divergence occurs when there are no clear directional trends, and traders take action based on divergence. This is usually done by taking positions on each side of the trade.
Find out what divergence trading in forex is, how to use divergence indicators for finding it, and how forex traders use it for their trades in the market by continuing reading.
Divergences: Indicators and Signals to Follow
What does divergence in trading mean?
Divergence often appears on oscillating indicators (those that rotate around the midline). Indicators like MACD, RSI, Stochastic, and CCI are among them.
Indicators for volume, however, also show divergence. This indicator is more important than technical indicators. Divergence trading, however, uses the same principles for all indicators. Divergence tells us that the present impulse has ended or the price is preparing for a reversal.
It is important to remember that divergence is not an indication to enter the market. Rather, it would help if you had the main signal, and then the divergence will confirm the main signal.
Technical analysis should follow all the principles of technical analysis. For example, a technical indicator based on price performs similarly to other technical indicators.
However, it isn’t easy to talk about divergence’s effectiveness in practice.
Divergence and the ratio of traders’ positions are also known as positions. When most people want to buy, the price goes down, which is also a discrepancy.
The forex divergence tells you what?
In forex, divergence occurs when price movement is compared with a specific indicator (often an oscillator).
The oscillator should most often reach higher high levels when the price reaches higher high levels. As a result, lows have also been made on the oscillator if the price is also making lows.
The oscillator and the price diverge if this doesn’t occur.
Divergence in trading–how does it work?
The change in the direction of the indicator is interpreted as a signal that the price will soon follow. Therefore, leading indicators are used in this scenario as price indicators.
The price divergence shows a slowdown in the price’s momentum, analysing market prices. This is because prices change based on momentum rather than the price itself.
Imagine tossing a frisbee against a strong wind. In the beginning, the frisbee will fly against the wind. Then after slowing down, it will change directions and follow the wind.
Divergences form in what way?
Hence, divergence trading can not only be used to time trade entries within trends, but it can also assist you in understanding support and resistance levels.
Divergences can be broadly classified into four types, but all four differ in that they appear to reflect price exhaustion when the oscillator fails to confirm either new highs or lows.
Throughout all time frames, divergences occur all the time. However, the best results typically come from detecting divergence over longer, such as four-hour sessions or more.
The most common mistake with divergence trading is that traders anticipate certain behaviours from the price when a divergence is spotted. That’s a mistake! It doesn’t mean the price will reverse just because a divergence occurs.
In the charts outlined in this article, you will find that some divergence setups were accompanied by price moves in the opposite direction from what was being indicated by the indicators.
What is the formula for calculating divergence day trading?
Vertical alignment of your price chart and indicator is essential. The two must be aligned over the same period for a fair comparison.
In the event of a trend reversal, place your stop loss close to the point of reversal. Allow the pivot point to be re-tested if necessary with a small buffer. Just make sure it’s small. Unless the reversal holds, you will want out. Cut your losses quickly.
A price target that is a multiple of your risk can be set if the trend goes in the direction you expect. Alternatively, the key support and resistance levels can be used as targets.
Keep an eye on what’s going on over the long term, as well. For example, if you plan to trade based on 15-minute charts, make sure you check the one-hour charts first. Likewise, you should check the four-hour chart before trading with the one-hour chart.
The larger picture becomes clearer when you go up in time. Once you reach the target period, you can place your trade. A sniper’s always aware of their surroundings.
Trading Divergence: 5 Rules to Follow
- Confirm divergence always
Before you enter a trade, do this.
- Bring the highs together
Always connect the tops of the candlesticks when drawing a trendline connecting higher highs.
- Bringing the lows together
Connect the candlesticks’ bottoms whenever you draw a trendline connecting lower lows.
- Don’t chase divergences
Don’t trade a trend that is already in progress when you miss the pivot point. Keep watching.
- Adopt a longer timeframe
It’s okay for some traders to use 15-minute charts. However, they might still contain some noise. The most accurate readings come from a one-hour chart.
What are the best indicators using divergence?
Any oscillator indicator can be used to find divergence. Depending on the currency pair and indicator selected, the results may differ. We have compiled the top three that you might find very useful from all the oscillator indicators out there.
1. MACD indicator
For spotting early trend reversals in currencies, the MACD indicator can be very useful in identifying divergences. It can be used on any timeframe using the default settings. For best results, use one hour. Using the support and resistance levels, you can use the take profit and stop-loss at fixed 20 pip distances.
2. Commodity Channel Index
Divergence can also be measured using the CCI indicator. Exiting a trade when it is oversold or overbought is possible! The default settings enable it to be applied to any timeframe. A 15-minute, 30-minute, and 1-hour timeframe are recommended, however.
Divergence is commonly measured by stochastics. Based on the indicator, overbought or oversold conditions can exit the trades. The recommended time frame is 1-hour.
Divergence trading types explained.
Stock trading divergences can be divided into four types: regular divergence includes two types, and hidden divergence includes two types. Regular divergences indicate the trend will reverse, whereas hidden divergences point to continuing trends.
- A bearish divergence occurs when your preferred indicator gives you lower highs while the price makes higher highs. In most cases, the price will make a rapid downward move.
- Bullish divergence: A bullish divergence is the opposite of a bearish divergence. The price will create lower lows when the indicator indicates higher lows, indicating the price will be on an upward trend.
- Hidden bearish divergence: Indicator creating higher highs while the price is making lower highs is known as a hidden bearish divergence. A hidden bearish divergence indicates a downtrend will prevail.
- Hidden bullish divergence: Indicators show lower lows while the price creates higher lows. This is a hidden bullish divergence. It is most likely that the trend will remain upward in this instance.
Different Types of Divergence in Forex
3 Helpful tips to follow on how to trade divergence
Below are a few tips to follow on how to trade divergence:
1. The Right Time to Enter a Trade
It’s important not to get swept up in a trade when you see divergence on the chart. Instead, watch the price action to see whether it confirms the signal.
The price needs to go beyond the trend line to confirm a reversal. Breaking support or resistance is another good entry point. It would help if you used either of these entry signals to place a trade once you noticed them.
2. Put in a stop-loss order.
An order to stop your loss can protect you if the market reverts against your trade. Stop-loss orders should be set above or below the top or bottom of the reversal.
The idea is to ensure that you do not breach the previous swing point to catch a new trend just starting.
3. Choosing the Right Profit Target
Divergence trading can be improved by using a variety of profit target methods. Chart trend lines are one of these methods. The trade can be closed as long as the price does not break the trend line.
Alternatively, you can keep an eye out to see when a stock starts making lower highs or higher lows. It is a sign that there is an approaching divergence, going the opposite way from your position.
Is trading divergence profitable?
Indicators filter prices. Not always, but sometimes! In some situations, that filter can help us focus on what is important, while in others, we can miss what is important.
As a trading signal, divergence is useful for determining when to enter a trade since it signals before the price trend has changed. A good entry price for trade results from this early signal.
Divergence can sometimes give false signals as part of an effective trading system. Despite the name, it occurs when the indicator changes direction, but the price trend does not reverse. In many cases, the trend will lose momentum but will remain intact. Overbought or oversold conditions will quite often cause this to happen.
What is the best way to confirm divergence?
There are some tried-and-tested techniques to minimise the number of false signals and maximise the number of profitable trades.
Don’t heed divergence signals unless they indicate a change in trend. Alternately, don’t heed them if the market is range-bound! Instead, take only bearish signals from the RSI when markets are bearish and only buy signals when bullish.
An indicator will give a signal based on the candle’s current state. The candle that confirms divergence should always be closed. Divergence signals can disappear as quickly as they appear if the candle closes differently.
In addition, to support and resistance levels, round numbers, pivot points, or the price action trading patterns, confirm the signal using other indicators.
Related questions: FAQs
1. When should you trade divergence?
Look for divergences on longer charts or 1-hour charts if you want to trade successfully with divergence. Sometimes traders use 15-minute charts, which creates too much noise and wastes time.
2. What are the times when you shouldn’t trade divergences?
The RSI will make similar highs during an uptrend, which means the trend momentum will be unchanged. If the RSI makes a new equal high, it does not qualify as a divergence as it simply means that the uptrend strength is continuing to grow at its current level. Therefore, the RSI does not show weakness or a reversal at higher highs.
3. What is your method for confirming divergence?
Divergence signals should only be taken in the direction of the long-term trend. When you see a divergence, please wait for the candle that confirms it to close. Besides support and resistance levels, round numbers, pivot points, and price action patterns, other indicators can also be used to confirm the signal.
4. Divergence in trading has how many types?
The use of confirmatory signals will increase the likelihood of your trading success. Three types of divergence exist: regular, extended, and hidden. Any oscillator, such as MACD, CCI, or stochastic, can be used to find the divergence.
5. Divergence and its significance: what is it?
Physicists define divergence as the rate at which a vector field’s “density” leaves a given region. Hence, it is immediately possible to estimate how dense the interior has become by analysing the net flux of content passing through the surface surrounding the space area.
Divergence trading strategies can be an invaluable addition to your trading repertoire if you learn them well. Many professional traders use these strategies daily to qualify the profitable entry and exit points.
Traders usually use divergence trading strategies and their existing trading systems, so they don’t rely on divergence alone. For example, many traders personally use Top Dog Trading (TDT). This system teaches stochastic patterns, such as mini-divergence patterns, which can be found in the Second Chance patterns category.
Traders who make successful decisions outperform 95% of their competitors. Successfully requires psychological discipline, great money management, and a lucrative trading system. Traders who learn to trade divergence like pros might have the edge over the average loser.
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