Important Points to Consider While Trading Divergences
As a trader who works with other tools and ideas, divergences are among my preferred trading ideas since they provide very reliable and high-quality signals. The lagging behavior of indicators – and that of price action – can prove beneficial to our trading activities when studying divergences as we will see below. It is not just reversal traders who can profit from divergences, but trend-following traders alike can benefit from them as well.
What is divergence?
As a starting point, let’s discover what a divergence is or what it means about price. The number of people who get this right already will surprise you.
An indicator you’re using types an inferior high than the price on your chart, causing a divergence. An indicator that is available in sync with your price action means that “something” is trendy on your diagrams that must be dealt with immediately. However, it might not be so obvious just by looking at your value chart.
An indicator’s divergence occurs when its movement doesn’t match the price action. The terminology is quite basic, but it serves as an important building block for additional advanced divergence ideas.
Currency price movement diverges from technical indicator movements when the two move in opposite directions. A weakening price trend may signal a change in price direction, in some cases as a warning sign.
Generally, if the exchange rates are the same, both forex indicators and currency prices will move in the same direction. Accordingly, when the price moves to a higher high, the indicator supposedly follows suit. It is expected that the indicator will move in the same direction as the price reaches a lower high. This principle also applies to lower lows and higher lows.
There is a possibility that a change of sorts is about to occur when the price and the related indicators are out of sync. To put it simply, divergences are calculated as a result of highs and lows in price and their related indicators.
Though it’s not often used, divergence is a rather profitable strategy if applied with caution. However, divergences are not always accurate and timely indicators of trend reversals. Moreover, the divergence is not necessarily followed by a reversal of price.
Regular Divergence
There are two kinds of regular divergences: bullish and bearish regular divergences, and they are both used to advertise trend reversals.
If the indicator and the price make different lows at the same time, this is known as a bullish divergence. As value and momentum must move simultaneously, if the gage fails to make a lower low, this may be a sign that the tendency is reversing.
Hidden Divergences
Hidden divergences do not signify the reversal of the trend, but they indicate the continuation of the fundamental trend. In addition to hidden divergences, hidden strong divergences and secreted bearish divergences can also be grouped. An indicator makes a lower low (LL) but the price makes a higher low (HL) during an uptrend. An upward trend is being signaled by this situation.
How to trade a divergence – the optimal entry
It is common for a divergence to be followed by an oblique alliance rather than a strong reversal. Defy the common misconception that divergences essentially sign a trend shift. Divergences simply signal a loss of momentum.
Adding confirmation tools and other criteria to your trading arsenal is important to avoid useless trade entries. Divergences alone are not powerful and many trader’s skills poor results when they trade only by divergences. Confluence factors are vital to the success of any trading strategy.
On the chart below, we can see how prices made two divergences but didn’t sell-off. This consolidation was the result of the divergences just mentioned.
Revisiting the RSI
(Relative Strength Index) RSI is by far my favorite indicator for identifying divergences. RSI evaluates how an average gain or loss compares to an average loss/gain over a particular period. If you have your RSI set at fourteen, it compares the bearish candles with the bullish candles over the past fourteen candles. A low RSI value means that the previous 14 candles had more and larger bearish candles than strong candles, and a high RSI means that the previous 14 candles had extra and larger bullish candles.
To interpret divergences correctly, it is important to understand your indicator’s highs and lows, and I always cheer traders to delve deeper than the curvy lines to discover its true significance.
The RSI can be used to compare single wave trends during trends and thus gauge a trend’s strength. These are the 3 situations, and the screenshots below show each one:
(3) In the case of bullish trends and strong healthy trends, the RSI will typically make higher highs. The newest trend wave had more and larger bullish candles than the previous trend wave.
How to avoid entering too early when trading divergences
Trading divergences is no different from using other tools. To avoid cumulating losses, you must wait for extra validation. In addition to divergences, these confirmation signals can make divergences even more valuable:
You can wait for a limit of moving averages when an even bearish or bullish divergence happens, which will give you an extra level of confirmation that the present trend has over.
Hold off on writing a long or short position on divergence – when intriguing a trend line on an indicator, you can wait until the indicator breaks the trend line before incoming a long or short location.