If there is a low-risk opportunity to sell high and buy low, what would you do? If you are going long, how can you exit at the top? How do you avoid having your profits wiped out by the subsequent downturn? If you think a currency pair will continue to fall, how do you find a low-risk entry point to go short? All of these can be achieved through divergence trading.
I. Divergence Trading
Divergence comes in three forms:
The first is the divergence between price and indicators, such as price and oscillators, price and trend indicators, and price and volume indicators.
The second is the divergence between technicals and fundamentals, such as the divergence between price trends and fundamentals.
The third is the divergence between markets or between different assets, such as the divergence between the Dow Jones Industrial Average and the Transportation Index. Of course, there may be other forms of divergence, but these three are mainly used in our current trading.
The divergence we discuss mainly refers to the divergence between exchange rates and oscillators, such as price and Relative Strength Index (RSI), price and Stochastic Oscillator, price and MACD, price and CCI, price and KD, etc.
The biggest advantage of divergences is that they can serve as a leading signal, similar to candlestick patterns and Fibonacci lines, so they can be cross-referenced and filtered. Moreover, after some simple training, you can easily identify divergences. We have encountered a well-known domestic forex analyst whose main trading method is to look for divergences on the hourly chart.
If used properly, you can consistently profit from divergences. Since divergences help you sell near the top and buy near the bottom, they offer a good trading perspective. They provide a better risk-reward ratio because you can set a smaller stop-loss and achieve a larger profit.
How to Identify Divergence? First, consider “higher highs” and “lower lows.” If the price creates a high, the oscillator should also create a high to indicate that the momentum of the price movement is sufficient and the acceleration of the price rise has not decreased. If the price creates a low, the oscillator should also create a low to indicate that the downward trend of the price movement is very likely to continue.
If this is not the case, that is, if the price’s high does not coincide with the oscillator’s high, or the price’s low does not coincide with the oscillator’s low, then this is divergence, which is the divergence between the price movement and the indicator movement.
There are two types of divergence: Regular Divergence and Hidden Divergence.
II. Regular Divergence
A regular divergence is used as a potential signal for a trend reversal. If the price creates a lower low, but the oscillator gradually rises, then it is a typical bullish divergence, also known as a bullish bottom divergence. If the price creates a new high, but the oscillator gradually decreases, then this is a typical bearish divergence, also known as a bearish top divergence.
III. Hidden Divergence
A hidden divergence is often seen as a signal that the trend is more likely to continue. If the price creates a higher low, but the oscillator creates a lower low, then this is considered a bullish hidden divergence, implying a bullish bottom divergence. If the price creates a lower high, but the oscillator creates a higher high, this is a bearish hidden divergence, also known as a bearish hidden top divergence.
IV. How to Trade Divergence
Divergence acts like an early warning signal, telling you when the market is about to turn. For example, in a rising market, EUR/USD creates a new high, but the indicator’s high is declining. The appearance of a top divergence indicates that the market’s rise is at its end, and a downturn is not far away.
It’s important to note that divergence is just a signal, not a sufficient condition for establishing a position. Any signal needs to be cross-validated and filtered with other different types of indicators. Divergence is no exception. Divergence is often associated with double tops and bottoms, head and shoulders tops, and head and shoulders bottoms.
Another special type of divergence is when the price’s two highs are level, but the indicator’s highs are declining, or the price’s two lows are level, but the indicator’s lows are gradually rising. This is also a variation of regular divergence. Hidden divergence is used less frequently, so focus on mastering regular divergence and its variations. Variations can often be combined with double tops or bottoms for analysis.
Trading rashly based on divergence signals is very dangerous. If you are not very certain about the direction of the trade, it is best not to trade, or if you do trade, use a much lighter position than usual.
Divergences do not occur often, but they do exist. You can look for divergences on the 4-hour and 1-hour charts of major currency pairs, preferably looking for divergence between the exchange rate and the MACD signal line.
Based on our experience, this is indeed very effective. Normal divergence patterns can help you make substantial profits because you can choose the right position and direction to enter the trade. Hidden divergence helps you maximize profits and maintain the correct trading direction.
What we need to do is closely monitor the movement of prices and indicators, identify those divergences, and choose situations that are confirmed by other signal filters for trading. If it is just a divergence, it is not enough to enter the trade. Be cautious and design your trading roadmap.
V. Nine Rules of Divergence Trading
Here are nine important rules for divergence trading. Study them well and actively apply them in practice to make profits. Then you can re-evaluate and update these rules to create something of your own.
1. Rule One
The price must have one of the following patterns for divergence to be possible:
(1) Higher highs;
(2) Lower lows;
(3) Double tops;
(4) Double bottoms.
The recent price must satisfy one of the four patterns above, then check the indicators. If the price does not satisfy any of the patterns, you do not need to check the price anymore. Because divergence cannot exist.
2. Rule Two
Now that you have found a pattern that meets Rule One, specifically higher highs, lower lows, level highs, or level lows. Now connect the two highs or lows with a straight line. The two peaks or troughs must be consecutive and adjacent, not separated by other peaks or troughs of the same magnitude.
3. Rule Three
When performing Rule Two, when connecting two peaks, do not confuse it with connecting two troughs; similarly, when connecting two troughs, do not confuse it with connecting two peaks. To avoid confusion, you should operate according to the four types of divergence models mentioned earlier.
4. Rule Four
You have connected two peaks or two troughs. Now look at the indicator you have chosen; we recommend MACD, RSI, and the Stochastic Oscillator. Whatever indicator you choose, you must compare its two most recent adjacent tops or two adjacent bottoms. Most oscillators have two signal lines, and you can choose either one to compare with the price.
5. Rule Five
If you have connected the two most recent fluctuating high points of the price, you must connect the two most recent high points on the indicator line. Conversely, if you have connected the two most recent fluctuating low points of the price, then you must connect the two fluctuating low points on the indicator line.
6. Rule Six
The two points of the price must correspond one-to-one with the two points of the indicator, at least very close.
7. Rule Seven
Divergence exists only when the slope of the line connecting the price is positive and the slope of the line connecting the indicator is negative, not both positive or both negative.
8. Rule Eight
If you find a divergence and the price has already reversed, then the divergence may have already had its effect and become invalid, so it is best not to trade in this case. At this time, what you can do is look for the next opportunity.
9. Rule Nine
Divergences that appear on relatively larger time frames provide more accurate signals. Use divergences on the 1-hour chart or above, so you are less likely to get false signals. Although the opportunities for divergence trading you can engage in are reduced, your potential profits increase because you have limited excessive losses.
Divergences on time frames below the 1-hour chart occur frequently, but their reliability is very poor according to our experience, sometimes continuous divergences occur, but no reversal happens. Therefore, we suggest you look for divergences on the 1-hour chart or above, and it is best to look for them on MACD, which will bring you many surprises.