A financial market is an uncertain place. One cannot predict the exact movement of the price of any instrument in the market. But traders and analysts can at least predict the trend that may follow with the indicators’ help. The trend basically means the expected direction of the price of a particular instrument or security. There is more than one type of indicator, and each of them has its own process of predicting the pattern of a trend in price.
Indicators can provide signals for almost all the financial instruments but most importantly for Forex. One can have a real-time analysis of the complete price movement in the market.
What is a divergence in forex trading?
Divergence is the price movement process when an asset’s price (currency pair) moves in the opposite direction of a technical indicator, usually an oscillator. Divergence warns that the current price trend may lead to a price-changing direction.
Divergence is a situation in the market when there is contradictory movement between the oscillator, for example, RSI, and the price of an instrument. In only theory – divergence warns the trader not to believe in the price movement as the situation may get reversed, i.e., the asset’s price will start moving in the opposite direction of the current trend.
Understanding the divergence can be more clear if you are using it with a combination of indicators. One can choose among many available indicators. The most commonly used are the Relative Strength Index (RSI), Moving Average (MA), Bollinger Bands, Stochastic Oscillator, and many more. If the trader or the analyst can understand the pattern correctly, they will know the correct time to enter or exit the market without facing any loss or may make some profits.
As the name suggests, ‘divergence’ is meant to indicate a change in direction. Here, in the trading market, it indicates the change in the movement of price. The price of a security and the trader’s indicator should move in the same direction or indicate the same trend. But when they do not agree with each other, the result is divergence.
The divergence can be both negative and positive. The positive divergence signals that there may be a positive (upward) movement in the price. It is indicated when the technical indicator is moving higher, but the price is moving lower. This type of signal is known as a bullish signal or bullish divergence.
The negative divergence signals that there may be a negative or downward trend or movement in the price. It is indicated when the technical indicator shows a lower movement, but the price shows a higher movement. This type of signal is known as a bearish signal or bearish divergence.
These divergences lay between the high points, and the low points showed by the price and indicators. Thus, depending upon the position of the price and the indicator, divergences can be classified into four types.
4 types of divergence in forex are:
- Regular Bullish
- Hidden Bullish
- Regular Bearish
- Hidden Bearish
Let’s understand these 4 types of divergences in detail.
Regular Bullish Divergence
Regular Bullish Divergence is a usual signal of an upcoming bullish trend in an instrument’s market price. This divergence indicates a lower low price, but the indicator shows a higher low. Regular bullish divergence indicates that an upward trend will replace the ongoing bearish or downward trend. At this point, traders may go long, expecting a favorable return on their investment.
Regular divergences are perfect indicators of a possible reversal in the trend.
Hidden Bullish Divergence
Hidden Bullish Divergence also shows a possible upward trend but with a signal that the trend will continue. It means that if it is an upward trend, it will continue to go upward. It is indicated when the price shows a higher low, but the indicator shows a lower low. This marks the end of a downward trend and indicates a start and continuation of an upward or bullish trend.
Regular Bearish Divergence
Contrary to the Regular Bullish Signal, Regular Bearish Signal shows an approaching downward trend in the market. This is indicated when an asset’s price shows a higher high while the indicator shows a lower high. This divergence occurs in the uptrend that signals the traders to find a way out of the market before the downtrend approaches.
Hidden Bearish Divergence
When the downward trend approaches with a signal of continuation, it is known as Hidden Bearish Signal. It indicates that the price will start to fall and will continue to fall for a while. This divergence approaches when the price shows a lower high while the indicator shows a higher high.
How to trade divergence in Forex?
To trade divergence in the forex market, you need to identify the moment when the trading price moves in the opposite direction of the oscillator indicator such as MACD or RSI. After bullish or bearish divergence identification, you need to enter into a trade when the price touch an important price level (previous support, previous high, Fibonacci level, Pivot level).
The best divergence trading strategy uses the RSI 50 level principle.
The Best Divergence Trading Strategy
The Best Divergence Trading Strategy is based on the assumption that the fastest rising or falling trend on the chart is around 45 and 55 Relative Strenght index. Therefore, if we create an experiment and make buy or sell trades based on Relative Strenght Index RSI divergence, the best results for bullish and bearish trades will be when the RSI value is around level 50.
Divergence trading strategy steps are:
- Identify when the trading price moves in the opposite direction of the oscillator indicator such as MACD or RSI.
- Wait that the RSI signal is between 45 and 55 levels.
- Enter into a BUY trade if the RSI signal is between 45 and 55 levels, oscillator price rises, and the price trend line is bearish.
- Enter into a SELL trade if the RSI signal is between 45 and 55 levels, oscillator price is a downtrend, and the price trend line is bullish.
See an example of the weekly Divergence Trading Strategy:
I picked a long-term period, weekly chart, to better see how the divergence strategy works.
On this GBPJPY weekly chart, we can see on August 23. 2009 bearish trend. RSI indicator is in a bullish trend. But several months’ price was going down. The bullish trend started in February 2012. So all most 3 years in bullish divergence and price went down.
The bullish divergence rising trend started around 50 levels.
The same 50 level divergence principle can be applied on divergence day trading strategy, hourly chart, or daily chart. However, the applied divergence strategy performs best on long time frames such as daily, weekly, and monthly charts.
Divergence in Forex Trading
With careful practice and using the right indicator, one can easily get used to tracing divergences in the charts. But in certain cases, one must not confuse small differences between the price and the indicator’s movement as a real divergence. Understanding this concept can prove to be profitable for you. For example, one who is well aware of the divergences knows that it is suggested to sell when the price is at the top and buy when the price is at the bottom.
Divergence brings out the analytical strength of a trader. Once you are comfortable trading with the divergence, you can move upward in the market with this acquired knowledge. Trading in instruments like Forex will become much easier with time. It is an amazing tool and can prove to be a friend who warns you of any market changes.