Divergence Forex Trading Strategy Revealed
BY Chris Andreou
|May 6, 2022If you’re reading this then you are no doubt aware of the power that divergence has in Forex trading. You may also know how important it is to find an effective way of using divergence as a trading signal that can help improve your Forex trading.
Divergence is probably one of the most widely used indicators in technical analysis. The divergence Forex trading strategy is widely regarded by many traders as one of the best tools they can use to help them make more accurate forecasts.
In this article I will explain what divergence is and how to identify it so you can use it in your Forex trading. So without any further delay, let’s get started.
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Trading Forex with divergence
As a trader, it is important to know whether the market is trending up or down. It is even more important to know if the trend is going to change so you can trade in the right direction. One of the best ways of doing this is by forming an opinion using technical analysis. There are so many methods and indicators you can use but in this article, we will be focusing on divergence.
What is divergence in trading
Divergence occurs when the price of an asset moves in one direction, while a momentum indicator moves in the opposite direction. Divergence is a popular indicator used by traders as it can provide signals for continuations or reversals in price trends.The main reason for its popularity is because it is simple to understand and apply, for both beginners and experienced traders.
Divergence between price and oscillating indicator
How to trade divergence on MT4 or MT5
The first step in using divergence as part of your trading strategy is to understand what it indicates and be able to identify when it occurs. You can do this by looking at charts and analyzing the price action alongside oscillating indicators. When you see divergence on your chart, it means that there may be a continuation, reversal or correction in the current price trend.
Note every type of divergence will signal a reversal, since divergences can be caused by other factors as well. Therefore, it is necessary to understand how to identify and use the most reliable types of divergences for trading purposes.
With that being said, like all trading indicators, nothing works 100% of the time. So it is important to use other indicators for confirmation and apply sound risk management when trading.
Now, let’s take a look at the most common types of divergences so you can better understand how to spot them.
Bullish regular divergence
The most common type of bullish divergence occurs when prices move lower but an oscillator moves higher over time. A simple example is when prices make a new low but the oscillating indicator forms a higher low. This suggests that while sellers may be losing interest in the market, momentum is shifting from bearish to bullish. When you see something like this, it may be a warning that the downward move is over or running out of steam and a correction or reversal may occur.
Bullish hidden divergence
This is practically the opposite of the bullish regular divergence. Bullish hidden divergence is a bullish signal, which appears when the price of an asset moves higher but the oscillating indicator moves lower. This type of divergence can happen during a trend to indicate a potential continuation of the trend. It can also happen after a down trend to signal a potential reversal after a price correction.
Bullish exaggerated divergence
Bullish exaggerated divergences occur when the oscillating indicator makes a relative high but the price makes a relatively equal low. This can occur during a price trend to signal a continuation or at the end of a downtrend to signal a potential reversal.
There isn’t much to remember here and you will quickly get the hang of seeing and trading divergences with some practice. When the price is moving in a wave-like fashion in one direction, but there’s some kind of deviation in the relative highs or lows in the oscillator, that is a divergence.
Now let’s take a look at the bearish types of divergence, they are just the inverse of the bullish divergence.
Bearish regular divergence
The most common type of bearish divergence occurs when prices move higher but an oscillator moves lower over time. For example, when prices make a higher high but the oscillating indicator forms a lower high. This suggests that buyers may be losing interest and momentum is shifting from bullish to bearish. When you see something like this, it may be a warning that the uptrend is exhausting and a correction or reversal in the trend may occur.
Bearish hidden divergence
Again we have the opposite of the bearish regular divergence. A bearish hidden divergence is a potential sell signal that appears when the price of an asset makes a lower high but the oscillating indicator makes a higher high. This type of divergence can happen in the middle of a trend to indicate a potential continuation or at the end of an up trend to signal a potential reversal.
Bearish exaggerated divergence
Bearish exaggerated divergences occur when the oscillating indicator makes a relative high but the price makes a relatively equal high. This can occur in the middle of a down trend to signal a continuation or at the end of an uptrend to signal a potential reversal.
These bullish and bearish divergences can be seen on all time frames, but they are more significant on the higher time frames. Such as daily, weekly or monthly charts. Therefore, it is better to take a top down approach when using a divergence trading strategy. To allow you to see the longer-term trend more clearly. Then you can work your way down the time frames to pinpoint your entries and exits.
This will give you the highest probability of success.
Divergence Forex trading examples
Here are a couple of examples of divergence patterns.
The first one is an exaggerated bullish divergence with the RSI. Price fails to make new lows and is being supported around the 1.2470 area. However, the oscillator is progressively making a series of higher lows indicating a potential shift in momentum.
Here is another example.
From this chart, you can see a regular bearish divergence that is shortly followed by an exaggerated bearish divergence. These two sell bearish signals would have worked out quite well as the price shortly sold off significantly afterwards.
I am sure if you look at these two examples more closely, you will also notice more divergences in price that could have acted as confirmation to stay with the trade or to think about an exit. Trading is not just about an entry signal, you also have to manage the trade and have a clear exit. For the latter, you can simply use a divergence signal in the opposite direction.
But in all cases it would be a good idea to use another indicator to act as the trigger. You want to be sure that price is actually making a high or low, and this is manifest in the oscillator too.
Read on to learn what indicators you should add to your chart.
Adding oscillating indicators to your chart in MT4 or MT5
To set your charts up with the required oscillating indicator, navigate to the insert menu option in your MT4 or MT5 trading platform. Then go to indicators > oscillators from the pop up menu that appears.
From the list of oscillating indicators, select MACD or Relative Strength Index (RSI) or Stochastic Oscillator. You can insert all three indicators but they practically provide you with the same information. Only one oscillating indicator is required, so choose the oscillating indicator that you prefer.
MT4 or MT5 oscillating indicators for divergence
What indicator is best for seeing divergence
The best indicator to see divergence would be an oscillating indicator. Really, any oscillating indicator can do as long as the indicator illustrates a change in the direction of momentum compared to the overall direction of the trend.
Oscillating indicators are usually attached to the chart, instead of being overlaid on the price. When you look at an oscillating indicator, the values of it should oscillate sideways between an upper and lower boundary to signify overbought and oversold conditions. Regardless of whether there is a clear up or down trend happening in the price. This is what you need to see if you’re looking for divergence with price.
The most popular ones used for divergence trading strategies are the MACD, RSI and Stochastic. I would suggest you investigate and use these.
Are divergence trading strategies profitable?
Many traders have found divergence trading strategies to be very useful in helping them determine when to buy or sell.
While divergence strategies could be profitable, there are some problems with using it. The main problem is that it’s a lot harder to identify the tops and bottoms than most people think. It’s easy to look at charts in hindsight and see when divergences happened in the past. But it can be much more difficult to see them happening in real time and predict what will happen next.
There are lots of different ways you can place trades based on divergence and there are also varying degrees of strictness in how you define a divergence. Some traders try to be more strict with what constitutes a divergence by waiting for three consecutive highs or lows in the price. Other traders use multiple timeframes and seek divergence on at least 4 time frames.
However, there’s no guarantee that your trade will be successful and you could end up losing money if you decide to trade this way.
What are the risks of trading divergences?
In general, there will always be disagreement about whether divergence trading strategies can be profitable or not among traders. After all, disagreement and difference of opinion is a natural part of trading. So divergence Forex trading strategies are only effective when you’re right about the divergence being present in the first place.Then there needs to be sufficient follow through in price in the direction of your trade.
Whenever you use an indicator to smooth out price data, it can be hard to distinguish between one event and a similar event because the indicator makes all events seem the same. In other words, what is the difference between this oversold condition and the previous one? The indicator won’t tell you that, it will only tell you that momentum is potentially shifting.
If you find yourself intrigued by this strategy though, it’s worth adding a personal touch to it. You can do this by using other methods such as price action and support and resistance levels to optimize your entries and exits. Remember, all trading involves risk and you should back test and practice to see the validity of any trading method for yourself before deciding to use it.
Conclusion
The basic idea behind divergence trading strategies is to identify when the price of an asset and the momentum from an oscillating indicator move in opposite directions. When this divergence occurs between the two, it could be a signal to trade a continuation or a reversal of the price trend.
If you are looking for a “set and forget” type strategy, this is not it. This is an active trading strategy that requires monitoring, adjusting and general management. You can make it more manageable by monitoring the higher time frames or you can get more trading opportunities and be more active on the lower ones.
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