Senior Analyst

Passionate about the markets, the excitement, the story driving the markets at the time, the fundamentals and even the technicals.

Forex traders utilize technical analysis and price movement to increase their chances of success.  There are numerous technical forex tools which a trader may utilize on a regular basis.  Divergence in the world of technical analysis takes place when the price of a specified asset moves in different directions.  Divergence is utilized to spot situations in which the price of an asset is moving in polar directions.   Divergence is usually considered either positive or negative and is an indicator/signal of significant shifts in direction of price action.  In addition, divergence takes place when swings in price diverge from the swings of your momentum indicator.  Examples of momentum indicators are MACD indicator, Stochastics indicator and RSI.

There are two types of divergence when utilizing technical analysis.  Positive divergence takes place when the price of a specific asset reach a new low and at the same time the indicator starts to move upward.  On the other hand a negative divergence takes place when price of the asset reaches a new high and the indicator neglects to do the same and closes lower than previous highs.

There are very specific rules a forex trader should observe when trading momentum and divergence.  The trader should recognize that for divergence to exist your price action needs to have formed the following; double top, double bottom, higher highs then the previous high and lower low than the previous lows.

Drawing lines on consecutive tops and bottoms is paramount when trading momentum and divergence.  The lines which a forex trader is tracking will show/observe one of four things.  Either you will see a lower low, a flat low, a higher high or a flat high.

Another aspect when utilizing a strategy to track momentum and divergence is to connect the tops once your swing highs have been established.  If two lows have been establish you need to connect the bottoms.  It is important to note that the trader should not make the mistake of drawing a line at the bottom when two higher highs have taken place.

Once the forex trader has connected either their two tops or two bottoms with a trend line, they should observe their preferred indictor and compare the indicator to price action.  Whichever indicator the forex trader utilizes, they should keep in mind that they are comparing the indicators tops or bottoms.  Indicators such as MACD or Stochastic have several lines connecting.

If the forex trader is connecting two highs on price they should also draw a line connecting the two highs on the indicator.  In addition, this rule also pertains to two lows.  If the forex trader draws a line connecting two lows associated to price they must also draw a line associated two lows on the same indicator.  Also, the forex trader must determine/identify indicators which line up vertically with that of the price highs or lows.

Divergence can only exist if the slope of the associated line connecting the respective indicator tops/bottoms is different from those of the slope of the line connections price tops/bottoms.  The forex trader should keep in mind that the slope must either be ascending and rising or descending and flat.  Also, the forex trader must understand that if they spot divergence and the price action has reversed and already moved in a specific direction for a period of time, the divergence should be looked at as played out.  In other words the boat has already sailed and the only thing a forex trader can do is wait for an additional swing of high/low to be created.

The history of divergent signals has told us that signals tend to be more accurate with longer time frames.  What this means is that you usually get fewer false signals and if the forex trader structures their trades well that they can make a boatload of money.  It has been known that divergence when utilized on shorter time frames occur frequently but are also less reliable.   Traders utilize divergence in different ways.  Some traders utilize divergence on one hour charts while other traders utilize divergence on fifteen minute charts.

There are different types of divergence.  The two charts below are good examples of regular divergence.  The forex trader should keep in mind that there is no such thing as an automatic trade.  If a forex trader sees regular divergence when assimilating two highs during an uptrend or assimilating two lows during a downtrend this does not equate to a sure thing.  Regular divergence is an excellent toll to resolve the question of whether or not the trend is increasing or losing speed.  Regular divergence during an up-trend compares higher highs in price action with the highs in the indicator.  The forex trader should be aware that both Stochastic as well as MACD typically have a lower high while price has a higher high.  What this mean is that the trend is getting weaker.

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In addition, the chart also indicates a strong example of 3pt RD which means that the lower low in the price does have a higher low in the MACD.  Also, RD can have 4pt as well as 5pt divergence in front of the trend really changing.

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Another form of divergence called hidden divergence compares price actions higher lows in price to those of price during an uptrend with those of lower lows in the indicator and the lower highs of price action in a downtrend.  When a forex trader is reviewing hidden divergence they are looking to help answer whether the trend will continue or not.

In closing, divergence is an excellent tool for the forex trader to leverage off of.  When mapping divergence the forex trader may be able to determine whether or not price action of a specific asset is actually moving in different directions.   Divergence is typically recorded as either positive or negative and indicates if significant shift in price action.  Also, divergence happens during swings in price from the swings of the forex trader’s momentum indicator.

 

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