One day trading strategy that is very well-liked by forex traders is the use of a technical indicator’s divergence from the movement in a market price.
If you spot market price volatility, do you know what technical indicator to use to maximize profits or minimize losses? Below, we’ll look at what a divergence is, which indicator is the best to find it, and how to recognize the correct trading signal from a divergence.
Table of Contents
What is divergence in trading?
Divergence is a technique used in technical analysis when an oscillator or other technical indicator deviates from the general price trend. In other words, the trading oscillator shows a potential trend reversal when the indicator starts moving in the opposite direction from the price.
Bullish divergence occurs when the price is trending downward while the indicator is pointing upward.
Bearish divergence occurs when the price is rising while the indicator is pointing downward.
NOTE: Whether a signal is seen as bullish or bearish depends on what the technical indicator is performing.
How does divergence in trading work?
Day traders interpret an indicator’s direction shift to indicate that the price may soon follow. In this case, the oscillator serves as a price leading indication.
Divergence is used to assess market price since the indicator is reflecting a slowing in price movement. Often, the price’s momentum will alter before the actual price.
Consider how a frisbee will behave if you toss it into a high wind: first, it will fly against the wind, then it will slow down, and finally, it will change direction and fly with the wind.
Which indicator is best for divergence?
Divergence trading does not have a single most popular indicator. Each technical indicator has advantages and disadvantages of its own. The three most often used indicators—RSI, MACD, and Stochastic—will be covered.
Trading Strategy: RSI for trading divergence
As an underlay indicator, the RSI indicator is a momentum indicator displayed as an oscillator with a range of 0 to 100 beneath the candlestick chart. By averaging the price gains and losses over the preceding 14 periods, the RSI is determined. J. Welles Wilder Jr. invented it in his book, “New Concepts in Technical Trading Systems.”
The indicator produces a smooth line that naturally tracks the price trend and is conducive to trading divergences. Few overbought and oversold readings are produced by the RSI indicator when it is set to the default 14-period value. Thus, although there are often fewer signs associated with employing divergence as a trading signal, when they do appear, they are more trustworthy.
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Trading Strategy: MACD for divergence trading
The MACD is a momentum indicator that works best in circumstances when trends are followed. A signal line and a histogram that displays the difference between two moving averages are both plotted by the trend indicator. As the trend develops and finally turns around, the moving averages will converge and diverge.
The histogram’s visual style is ideally suited to trading divergence, but it is less interpretable when a new “swing point” has been established. Choosing which trend trade signals are trustworthy enough to employ is more challenging because there is no pre-defined area of overbought and oversold in the MACD. This may be avoided by properly employing prior MACD peaks as places of support and resistance. Because it is best used in trending environments, the MACD will produce many false signals counter trend.
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Trading Strategy: Stochastic for trading divergence
Stochastic is a momentum technical indicator that works by comparing the last closing price with a range of previous prices over the last 14 periods.
Because the stochastic is a more sensitive indicator, it will provide more signs of divergence and, thus, more trading possibilities, but this also implies that there will be more false signals.
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Is trading divergence profitable?
Yes, but not all the time! We must keep in mind that indicators filter price movement. Depending on the trading strategy and scenario, that filter may assist us concentrate on what is vital or may cause us to overlook what is crucial.
Divergence as a trading signal for when to enter a trade has the primary benefit of providing the signal before the price trend has altered. The trader might enter their deal at a higher price thanks to this early indication.
Divergence as a component of a successful trading strategy has the drawback of occasionally producing “false signals.” As the name implies, this occurs when the indicator reverses course yet the price trend continues as the indicator had predicted. This will quite often happen when the indicator gets very overbought or oversold. The momentum of the trend will weaken but the trend remains intact.
How do you confirm divergence?
To minimize the amount of false signals and maximize the number of winning transactions, there are a few tried-and-true methods.
- Divergence signals should only be acted upon in the long term trend’s direction or alternatively in a sideways market that is range bound. For instance, only act on bearish RSI indications during a down market, and only act on buy RSI signals during a bull market.
- Always watch for the closing of the candle that is verifying the divergence. Indicators will send out a signal based on the candle’s current status. A trading signal from divergence might vanish as fast as it emerged if the candle finishes in a different way.
- Use other indicators to confirm the signal such as support and resistance levels, round numbers, pivot points or a price action trading pattern.
Should I trade using divergence?
In conclusion, trading divergence may be a useful addition to your trading strategy, particularly if you already use indicators like RSI or MACD to identify overbought and oversold levels, but it shouldn’t be relied on alone and needs work to master.
We’ve also put up the articles 3 Popular Forex Trading Strategies To Trade More Profitably and 3 Easy And Profitable Trading Strategies For Beginners to help you out a little. Check it out now!
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