The above chart displays a common case of extended divergence. There is extended bearish divergence, where the indicator hits higher highs while the price highs are getting lower (marked with blue lines). This signal should be followed by a false trend reversal.
It is clear from the above chart that the take profit, which is two times more than the stop loss, is hit by the price and exits our trade with the profit. To detect the divergence, you need to draw the line across the lows or the highs of the candlestick chart. Draw another line across the extreme points drawn by the indicator line or the histogram. The strongest signal is delivered by regular divergence. In an uptrend, for example, the regular divergeFor example, ince bearish is when the price hits higher swing highs, but the oscillator fails to break through the highs.
What other tools can traders use with divergence?
Divergences on shorter time frames will occur more frequently but are less reliable. All you can do now is wait for another swing high/low to form and start your divergence search over. Some indicators such as MACD or Stochastic have multiple lines all up on each other like teenagers with raging hormones. Once you see two swing highs are established, you connect the TOPS. Don’t even bother looking at an indicator unless ONE of these four price scenarios has occurred.
- You see that the histogram of the forex divergence indicator is getting close to zero.
- In the bearish divergence, the highs are getting lower.
- As a result of such an easy test, we can conclude that this divergence strategy is entirely accurate.
- So, you can use any oscillator that suits you best.
The false signal of divergence is when the convergence or divergence of the lines doesn’t result in the trend continuation or reversal as expected. In contrast, class B bullish divergences are demonstrated by prices tracing a double bottom pattern, with the indicator outlining a higher second bottom. A regular bullish divergence occurs when the price is making lower lows, but the oscillator is posting higher lows. This could signal a trend reversal and indicate that a recovery might follow.
Top tips for trading divergence in forex trading
We enter the short at the next bar when the stochastic shows the bearish crossing of the %K and %D lines (blue circle in the chart). Let us test the divergence trading strategy in the same case where we traded with the MACD. Divergence on the chart may occur if the direction of price movement and OBV are different. When the price rises and the OBV falls, this may indicate a possible price reversal down in the near future. If the price is falling and the OBV is rising, the price will likely turn up soon. The OBV measures the change in trading volume and adds or subtracts it from the previous value.
The study of momentum simply checks whether price and the indicator agree or disagree. To find out the divergence, you can use the histogram, as I described above. Price highs and the indicator highs should correspond to each other.
Next steps to test forex divergence
Divergence occurs when the price and the indicator move in opposite directions. This can happen if the indicator measures factors that are not directly related to price or if there are changes in trading volumes or volatility. When you use trendline to detail entry points, you should be able to draw it correctly. The downward trendline starts from the first trend high to the last local highest high in our example. In the previous example, with the bullish trend, the approach was the same, but the trendline was drawn across the lows. It should be stressed that divergence is a leading signal, while confirmation and reversal reflect the current market state.
Just like any trading strategy, you need to add more confluence factors to make your strategy strong. Most of the technical indicators used to follow divergence are momentum oscillators. The three most popular indicators for trading divergence are RSI, MACD, and the stochastic oscillator. As well as reversals, divergences can also indicate the continuation of a trend. Divergence typically means two indicators are moving apart, while convergence shows how they move together. It describes the phenomenon of the price of a futures contract moving toward the spot or cash price of the underlying asset over time.