Divergence involves comparing the movement of an indicator and price action, regardless of the indicator you are using. The indicator may be CCI, Stochastic, RSI, Fibonacci, ADR, or MACD among others. Divergence is formed on the chart when the market price makes a higher high, but the indicator on the chart makes a lower high. When your indicator and price action are not corroborating each other, it means that “something” is happening on your chart that requires your attention.
In summary, divergence exists when the market price action do not agree with your indicator.
With a proper understanding of the concept of divergence, it is possible to trade divergence and consistently be profitable. Divergence can be used as a leading indicator, and it is not difficult to spot with regular practice and study.
A big advantage of divergence trading is that it gives the opportunity to buy low and sell high which will give a higher risk – reward ratio. It is expected that if the indicator should make a higher high when the market price is also making a higher high and if the indicator is making a lower low, the market price should also be making a lower low. If this is not happening, then there is a divergence between the market price and your indicator, and this is what is called “divergence.”
Divergence trading can help to determine if a dominant trend is coming to an end or if there will still be a continuation of the prevailing trend.
There are TWO types of divergence:
Important things to note about Divergence Trading
- For Divergence to occur, the market price must form either of the following:
- A Double bottom
- A Double top
- A Lower low than the previous low
- A Higher high than the previous high
Make sure any of the above-listed conditions have been fulfilled before even looking at your indicators
- Connect tops and bottoms with trend lines, and now compare with what your indicators are saying, you may use indicators such Stochastic, RSI or MACD.
- Draw a line connecting two highs on price and also, draw another line connecting two highs on the indicator. If you are considering low, you do the same thing by drawing a line connecting two lows on price and another line connecting two lows on the indicator. Divergence is said to exist if the slope of the line linking the indicator bottoms or tops is not the same as the slope of the line that links the bottom or low. The slope must either be descending (falling) or be ascending (rising) or flat.
Divergence, when spotted on higher time frames, are more reliable as the higher time frames are less susceptible to the market noise although this may mean fewer trades and will require patience to spot trade opportunities. Divergence trading is advised to be practiced on time frames from 1 hour, 4 hours, and daily. Trades on these higher time frames if well spotted have a good potential to go as speculated.
Go Back Posted on April, 2017