13 April, 2023

The Importance of Divergence Analysis in Forex Trading

At the point that momentum wanes, you then scale out of the position by taking progressive profits on your fractional trades. 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. Positive divergence indicates a move higher in the price of the asset is possible. Negative divergence signals that a move lower in the asset is possible. HowToTrade.com takes no responsibility for loss incurred as a result of the content provided inside our Trading Room.

  • You should use any confirmatory signal to add further probability of success to your trading.
  • Use our profit calculator to calculate the possible profit from a trade you are considering taking.
  • Divergence only exists if the SLOPE of the line connecting the indicator tops/bottoms DIFFERS from the SLOPE of the line connection price tops/bottoms.
  • Also, in cases, where you sometimes hesitate to take profit because you want to…

However, it could be a valuable addition to your existing strategy. For example, the price on the chart  you are looking at has just made a new higher high, but the indicator is making a lower high. Follow these rules, and you will dramatically increase the chances of a divergence setup leading to a profitable trade.

How to trade a hidden divergence

The exaggerated bullish forms when price forms two bottoms almost same level as the indicator forms bottoms with the second one higher than the first. When in a downtrend, it gives a signal that the downtrend is still strong. On the other hand, when formed at the traders way broker introduction end of an uptrend, it may lead to reversal. When price makes a higher high but the indicator forms a lower high, that shows the bulls are losing momentum. When there is a difference in the movement of indicators and prices, then something is fishy in the market .

  • The above chart is an example of the wrong reading of divergence forex.
  • In the paragraphs below, we will explain two trades that were made because of several MACD histogram divergences that appeared on the USD/JPY daily charts.
  • When there is a bullish divergence, it is worth getting ready to buy, as the chart will go up.
  • The OBV measures the change in trading volume and adds or subtracts it from the previous value.
  • Divergence is a powerful tool that can help traders identify potential reversals and trend continuations in the forex market.

Unlike regular divergences, they signal trend continuation. These signals are good for trend trading and for filtering false signals. So, you can easily spot a divergence in the price chart. Let us now explore different types of forex trading divergences. They are regular divergence (also, classical or normal), hidden divergence, and extended (reverse) divergence.

Manage Risk

This strategy reduces risk by allowing investors to enter or exit positions at optimal times rather than trying to anticipate market movements that may not happen at all. You can gain insight into the forces driving current and future prices by using technical indicators to recognize discrepancies between pricing activity and the underlying trend. If the asset’s momentum rises, then regular Divergence could signal a potential uptrend in the future. Like in bullish divergence trades, stops should be set just above the high of the reversal candle. By watching out for these discrepancies, traders can take advantage of high reward-to-risk trades by entering short positions when the Divergence appears. Procrastination to trade is when your trading set up confirms and you hesitate to take trade.

Divergence can occur in any market, but it is most commonly used in the forex market. Traders can use divergence to identify potential changes in the trend and adjust their trading strategy accordingly. For example, if a trader identifies bullish divergence, it’s a sign that the trend may be changing from bearish to bullish. Traders can use this signal to enter a long position or exit a short position. It should be stressed that divergence means that the price chart and the indicator are going in opposite directions.

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. 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 above figure displays the extended bullish divergence on the MACD indicator. The price lows are roughly equal (slight deviations are acceptable). However, the MACD second low is higher than the first one. A hidden bullish divergence occurs when the price hits higher lows while the indicator forms lower lows.

Regular Bearish Divergence

Besides, due to the special design of the MACD, the indicator gives a divergence signal both on the histogram and using moving averages. Blue lines mark the divergence between price highs inverted head and shoulders pattern and RSI highs. I enter a trade when the RSI line goes outside the overbought zone (blue horizontal line in the chart). I marked the point with the green circle in the chart above.

Hidden Divergence forex: Convergence

It is clear from the above chart that the take profit, which is two times more than the stop loss, is hit by the price and exits our trade with the profit. In conclusion, divergence analysis is a powerful tool that can greatly enhance forex trading. It enables traders to identify potential trend reversals, confirm trade setups, and spot potential trade exits. By incorporating divergence analysis into their trading strategies, traders can how does forex work improve their decision-making process and increase their chances of success in the forex market. A regular bearish divergence occurs when there is a miscorrelation between an asset’s price in an uptrend that makes higher highs and a technical indicator that makes lower highs. Forex trading is a complex and dynamic market that requires traders to analyze various technical indicators and chart patterns to make informed trading decisions.

If the price closes lower than the previous day, it is subtracted. Thus, the OBV indicator shows the relative strength of bulls and bears in the market. The above figure displays an example of a reasonable stop loss, marked with the red line. It is a bearish divergence, so the stop loss is set a little higher than the local high. So, having learned the theory and the practical application of divergence, we can make up a step-by-step guide to trading divergence in forex. After the first bar closes above the trendline, we enter a long.

For the stochastic, I took the recommended settings for the daily timeframe from the article here. I used the default settings for the Relative Strength Index. Unlike the oscillators covered above, the Awesome Oscillator divergence indicator looks like a histogram, not like a curved line. The trading strategy with the Awesome Oscillator is similar to that of the MACD histogram. The second most common error is when traders identify divergence simply by connecting adjacent peaks of the indicator bars. But they do not monitor whether these peaks occur within the same trend.

Regular Bullish Divergence

Then, once you find a contradiction between the asset’s price and the indicator’s reading, you have a trade. Traders interpret this phenomenon as a signal that the existing downtrend is losing momentum and a reversal is likely to occur. Trading divergences is a common strategy focusing on finding a miscorrelation between the asset’s price and a technical indicator. With this strategy, divergence traders are looking for price reversals or trend continuation signals to capture long price movements. And, if used properly, it can turn out to be a very rewarding and accurate way to find successful trades. Secondly, divergence analysis can provide early signals of trend continuation.

If, for example, the price hits lower lows in a bearish trend and the indicator is rising, this is a bullish divergence that means a potential upward reversal. If you are not yet familiar with the Bollinger Bands indicator, I strongly advise you to read the article Bollinger Bands Indicator. I described the double Bollinger band trading strategy. In short, it suggests attaching two Bollinger Bands indicators to the price chart.

I have already mentioned that the Bollinger bands are well combined with the divergence signal. Bollinger Bands is a trend indicator, so we need an oscillator to define a divergence. We shall take the profit (green line) when the indicator goes into the oversold zone after the meeting of %K and %D stochastics.