Trading Strategy

How to Trade All Types of Divergence in Forex and Avoid Common Mistakes

February 28, 2021 | 12:37 pm | The 5%ers' Blog > Trading Strategy
February 28, 2021 | 12:37 pm
The 5%ers' Blog > Trading Strategy
How to Trade All Types of Divergence in Forex

Trading Divergences in Forex

The very concept of divergence means the discrepancy between the readings of two or more correlated data sources.

Imagine that you are sitting in the cockpit of an airplane, and then suddenly, the instruments begin to signal that you are sharply decreasing. At the same time, it is clear outside the window, and you see that everything is in order with the plane. This is divergence. 

* Fear not, the aircraft has successfully landed *

In trading, divergence is a mismatch between price peaks/valleys and indicator peaks/valleys.

 

What is a divergence in trading?

In most cases, divergence appears on oscillating indicators (those that “revolve” around the mid-line). These are indicators such as MACD, RSI, Stochastic, CCI, etc.

However, divergence also appears on volume indicators. It carries more weight than technical indicators. But the very principles of divergence trading are the same for every indicator. The appearance of divergence tells us that the price is preparing for a reversal or that the current impulse has worked out.

The first thing to remember is that divergence itself should not be a signal to enter the market. You must have the main signal, and the divergence will act as a confirmation of this signal.

This should be done according to all the canons of technical analysis. But in practice, it isn’t easy to talk about the effectiveness of divergence. Like other technical indicators, it is based on price, so it does not differ much from them in terms of performance. By the way, the ratio of traders’ positions can also be called divergence. After all, this is also a discrepancy when the majority is in buying, and the price goes down.

 

Types of divergence in forex explained

It should be kept in mind that there could be different examples of divergence in Forex. To enter the market more accurately, you need to see and distinguish the types of Forex divergences on different timeframes. Let’s consider each type separately.

 

Regular divergence

Regular divergence allows you to see a trend reversal. This is a good signal to sell short or buy long. If the divergence is bearish, the price chart will prepare for a downward movement. The Forex traders should prepare for selling. When there is a bullish divergence, it is worth getting ready to buy, as the chart will go up. By the way, examples of divergence in Forex can be different. The main thing is to correctly determine its type using the oscillator.

 

Regular Bearish Divergence

To identify bearish divergence in the market, a trader must look at the highs of the price (shadows of Forex candles) and the corresponding indicator. A classic bearish divergence will occur when certain conditions are met: a high should appear on the price chart, the indicator should show a lower high.

However, it is not at all necessary to observe higher maximum price values ​​on the chart. It is enough that the previous peak is slightly lower than the next one.

Regular Bearish Divergence

 

 

Regular Bullish Divergence

To determine the classic bullish divergence of Forex, you should pay attention to the lows of the chart, as well as the indicator. If the market has a regular bullish divergence, then the candlesticks will draw a lower price value, and the indicator, on the contrary, will draw a higher low. In this case, we should expect an upward movement; that is, the trader needs to get ready to buy.

Regular Bullish Divergence

 

How to trade regular divergence?

You should use any trend indicator like moving average to know the primary trend and get confirmation from divergence to enter a trade. For example, you can use 20 – period simple moving average. If you find a bullish divergence and the price is above the 20 SMA, then you enter the long position. You can place the stop-loss slightly below the recent swing low while the take profit can be placed near the next resistance level.

How to trade regular divergence

 

Extended Divergences

Extended Forex divergence is somewhat similar to the usual classic divergence. But in the case of extended divergence, the price forms a pattern that closely resembles a “double bottom” or “double top.”

Everything is clear with graphical figures, but how to determine the market’s direction if the indicators draw a second low or high, which are very different from the minimum or maximum prices in the terminal? If this feature is observed, then the price will continue to go in the same direction.

Extended divergence is of two types:

  • bearish;
  • bullish.

It is important to note that Forex extended divergence is one of the varieties of trend divergence in its classical sense. It can be observed when the market intends to slow down, but instead of changing its direction, it continues its movement in the same direction that it was before.

 

Extended Bearish Divergence

If there is an extended bearish divergence on the chart, it can only mean one thing; prices will continue to go down, so you need to look for a selling opportunity.

To determine the extended bearish divergence, the trader should pay attention to the peaks (highs) not only on the chart but also on the indicator. Typically, this kind of divergence is seen along the tops during a big move. The market draws a double top, but the second price peak may be slightly higher or lower than the previous value. Even if the top levels are the same, the indicator will show a lower second high. The indicator will not draw the double top that is seen on the price chart.

You can solve this problem differently. You don’t have to think about how to see the divergence. Suppose the price chart draws a double bottom or top, and the indicator does not repeat the formation of patterns like the market but shows a mismatch. In that case, this should be regarded as the formation of an extended bearish or bullish divergence.

Extended Bearish Divergence

 

Extended bullish divergence

If the chart shows an extended bullish divergence, you need to look for a buying opportunity as prices go up.

To recognize an extended bullish divergence in the terminal, it is necessary, first of all, to pay attention to the lower part or lows of not only the price but also the basement indicator. Usually, during an extended bullish divergence, quotes draw a double bottom.

Although the lows on the chart will be displayed at approximately the same level, the indicator will show a slightly different picture; the second low will be significantly higher than the first. If this condition is met, it means that we are dealing with an extended bullish divergence in Forex, and the trader should look for profitable moments to buy.

Extended bullish divergence

 

How to trade extended divergence?

If you see an extended divergence on the chart, then take the confirmation from any other indicator. If other indicators confirm the trend reversal, enter the trade with a stop-loss at a recent swing low/high with the profit target at the next support/resistance level.

How to trade extended divergence

 

Hidden Divergence in forex

In Forex, hidden Forex divergence informs about the continuation of the trend. However, it is rather difficult to recognize it in a trading terminal. Hidden Forex divergence gives a clear signal to open a buy or sell position.

If there is a hidden bearish divergence in the market, one can expect that the price chart will continue its downward movement. When there is a hidden bullish divergence on the chart, then the price will rise.

Hidden bearish divergence

To see the hidden bearish divergence in Forex, you need to identify the peaks of candles or highs of the price, as well as the indicator. The MACD indicator can be used to identify hidden divergence. This scenario emerges only when the price moves down. If the indicator shows a divergence at this moment, then a downward movement can be expected in the future.

Hidden bearish divergence

 

Hidden bullish divergence

To detect hidden bullish divergence, you need to pay attention to the lows of the chart, as well as the indicator. This kind of divergence occurs when the market is upward, drawing high lows, and the indicator reading lower.

Hidden bullish divergence

 

How to trade a hidden divergence?

If you see a hidden divergence, simply enter the trade with stop-loss around the recent swing low/high with profit target near the next support/resistance level.

How to trade a hidden divergence

 

Common mistakes while trading divergence

Most traders see divergence on the chart and simply enter the trade without thinking for another moment. The need is to filter the false signals and find a high probability trade setup. Hence, do not enter the trade impulsively rather wait for a brief pullback and then enter. Also, you can avoid a bad trade by following the candles. For example, if you see a bullish divergence, then wait for a bullish candle to appear and then enter. Do not enter a trade if there is a long wick on the upside of the candle.

 

What are the best indicators using Divergence?

You can find divergence with any oscillator indicator. However, the results vary with the currency pairs and the chosen indicator. Among all, we have shortlisted the top three oscillator indicators that can be very helpful in your trading.

MACD indicator

The MACD indicator can be very beneficial for finding the divergence and spotting early trend reversal in currencies. You can use the default settings of the indicator on any timeframe. However, it is better to use 1-hour timeframe. You can use take profit and stop-loss at fixed 20 pips difference or you can use the support and resistance levels as well.

Commodity Channel Index

The CCI indicator is another good choice to determine the divergence. It can be applied on any timeframe with default settings. However, it is recommended to use 15-minute, 30-minute, and 1-hour timeframes. You can use the oversold and overbought conditions to exit the trades.

Stochastic

Stochastic is a widely used indicator for divergence. The recommended timeframe is 1-hour while the indicator can be used to exit the trades based on overbought and oversold conditions.

 

Divergence in forex summary

Divergence is a means to find the early trend reversal signal. There can be three types of divergence, i.e., regular, extended, and hidden. You can use MACD, CCI, Stochastic, or any other oscillator to find the divergence. You should use any confirmatory signal to add further probability of success to your trading.

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