Divergences are a powerful trading concept and the trader who understands how to trade divergences in the right market context with the correct signals can create a robust method and effective way of looking at price. Higher highs on the RSI do not show a reversal or weakness. If you can dream it, you can become it. Now look at your preferred indicator and compare it to price action. When there is a discrepancy between price and the oscillator a divergence is identified.
Divergence trading is an awesome tool to have in your toolbox because divergences signal to you that something fishy is going on and that you should pay closer attention. Using divergence trading can be useful in spotting a weakening trend or .
If you draw a line connecting two lows on price, you MUST draw a line connecting two lows on the indicator. They have to match! If you spot divergence but the price has already reversed and moved in one direction for some time, the divergence should be considered played out. You missed the boat this time. Divergence signals tend to be more accurate on the longer time frames.
You get less false signals. This means fewer trades but if you structure your trade well, then your profit potential can be huge. Divergences on shorter time frames will occur more frequently but are less reliable.
We advise only look for divergences on 1-hour charts or longer. Classic technical analysis tells us that a trend exists when price makes a higher high — but like too often, conventional wisdom is seldom right and usually simplifies things too much. A trader who only relies on highs and lows for his price analysis often misses important clues and does not fully understand market dynamics.
Spotting a divergence on your momentum indicator, thus, tells you that the dynamics in the trend are shifting and that, although it could still look like a real trend, a potential end of the trend could be near. I am a pure reversal trader and early-trend trades after divergences are my bread and butter trades. A divergence does not always lead to a strong reversal and often price just enters a sideways consolidation after a divergence. Keep in mind that a divergence just signals a loss of momentum, but does not necessarily signal a complete trend shift.
A divergence alone is not something that strong enough and many traders experience bad results when trading only with divergences. Just like any trading strategy, you need to add more confluence factors to make your strategy strong. Below we see how price made 2 divergences but price never sold off. The divergences, thus, just highlighted short-term consolidation. Location is a universal concept in trading and regardless of your trading system, adding the filter of location can usually always enhance the quality of your signals and trades.
On the left side, you see an uptrend with two divergences. However, the first one completely failed and the second one resulted in a massive winner. What was the difference? Such an approach will impact your performance in a big way. Below, we will explain the method I used to trade it.
The Trade The second divergence signal seen in dark blue , which occurred between mid-December and mid-January , was not quite a textbook signal. While it is true that the contrast between the two peaks on the MACD histogram's lower high was extremely prominent, the action on price was not so much a straightforward higher high as it was just one continuous uptrend. In other words, the price portion of this second divergence did not have a delineation that was nearly as good in its peaks as the first divergence had in its clear-cut troughs.
For related reading, see Peak-and-Trough Analysis. Whether or not this imperfection in the signal was responsible for the less-than-stellar results that immediately ensued is difficult to say. Any foreign exchange trader who tried to play this second divergence signal with a subsequent short got whipsawed about rather severely in the following days and weeks.
However, exceptionally patient traders whose last stop-losses were not hit were rewarded with a near-top shorting opportunity that turned out to be almost as spectacularly lucrative as the first divergence trade. The second divergence trade did not do much for from a pip perspective.
Nevertheless, a very significant top was undoubtedly signaled with this second divergence, just as a bottom was signaled with the first divergence trade. To read about another trading lesson learned in hindsight, see Tales From The Trenches: Making a Winning Divergence Trade So how can we best maximize the profit potential of a divergence trade while minimizing its risks?
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According to proponents of divergence trading, this type of price-oscillator imbalance foretells a price correction of the imbalance. In this case, the correction in price would need to have been a directional change to the upside. Before you head out there and start looking for potential divergences, here are nine cool rules for trading divergences. Learn ’em, memorize ’em (or keep coming back here), apply ’em to help you make better trading decisions. Oct 06, · Forex Divergence trading is both a concept and a trading strategy that is found in almost all markets. It is an age old concept that was developed by Charles Dow and mentioned in his Dow Tenets. Dow noticed that when the Dow Jones Industrials made new highs, the Dow Transportation Index tends to make new highs as well and /5(26).