How do you trade divergences

To successfully trade divergences, first you have to know how to differetiate the different types of divergences in the market; there it will be easy for you to spot them.

For instance, when you spot a higher high than the previous high on the chart,the first thing to do is to look down on your indicator and try to compare the two to see if there is any kind of divergence. If they disagree, then there is a bearish divergence.

A double or triple tops pattern is likely to form on the market chart.  if you see that, try to join the tops together and a draw a trend line connecting the two tops.  The last top should be slightly lower than the first top. Do the same on the indicator you are using below the market chart. Incase you are using a MACD, the confirmation for going short is when the histogram crosses over to the lower side of the zero line. Target should be the same size as the height of the top and stop loss slightly above the tops.

When you spot a lower low than the previous low in the market, check immediately with your momentum indicator being used. If the indicator is making a higher low as price  makes a lower low or double or triple bottoms, there is a pontential divergence.

Like we did for double tops, use a trendline to join the highs and lows of the pattern and the bottoms. As price gets closer to the upper line and the histogram crosses the signal line it signals a shift in momentum and the crossover of the histogram above the zero line gives us a confirmation for a trend reversal.

Using the divergence our entry will be at the crossover of the histogram above the zero line. For instance let us see how we would trade the example above.

When trading divergences, you should keep in mind that when you spot a hidden divergence it necessarily means that a trend is getting ready for a pause or consolidation. There after it will continue to its direction after a pause.

As the indicator makes higher highs or lower lows and price fails to respond, it is an indication that the trend is too weak for the reversal and so gets in a consolidation. Prepare for a rally after a short rest.

Likewise when a regular divergence forms whether up or down trend, it signals a possible reversal from the previous direction, prepare to either enter or exit trade position.

For exaggerated divergence you can choose to open new positions by scaling or trailing the already open positions .

Now let’s look at different examples when using different momentum indicators to trade divergences.

Trading divergences when using a MACD

The MACD is a moving average convergence divergence indicator where a signal is taken on a crossover. After spotting divergences between price and the MACD, wait for a confirmation before taking any trade position on the MACD histogram crossovers with the zero line

The chart below shows how to trade divergences using a  MACD indicator.

Previously we talked about the different types of divergences that a likely to show up on the market chart.  If you can take a good look on the chart a bove, you will notice that the USD/CAD daily chart closed with a lower bottom/low. At the same time, the MACD made a higher bottom/low. This caused a bullish divergence between the price action and the Moving Average Convergence Divergence (MACD) indicator.

This gave  a good opportunity to take a long position on the pair and as a matter of fact, you can see how the USD/CAD moved upward after the divergence scenario. It is always important to wait for a confirmation by the MACD crossovers as circled on the chart above to avoid being faked out.

Follow the same procedure to trade any type of regular divergence when using a MACD. 

Let’s look at a second example when trading a hidden bearish divergence with a MACD.

Trading divergences when using Relative Strength Index(RSI)

The Relative Strength Index is also a momentum indicator used in forex trading to determine the overbought/oversold price conditions.

The RSI indicator is a leading indicator and consists of a single line, which moves between an overbought and oversold zone.

Apart from showing overbought and oversold conditions,The RSI chart is to identify trading signals as a result of divergences between price and RSI.

When you spot a disagreement between price action’s tops or bottoms and RSI’s tops or bottoms, it means a divergence pattern is forming. Once you get hold of the pattern, you can prepare for a price reaction depending on where the pattern is formed. It can either be a bullish divergence or a bearish divergence.

Forexample, let’s take a look on how to trade divergence using RSI as shown below.

From the above chart, price has been moving in an uptrend till it started forming higher lows.

If you can take a good look at the momentum indicator, RSI; it shows that as price was forming a higher low, it maintained its second low as the first one which calls for a disagreement between price action and the RSI indicator. This is known as a hidden bullish divergence.  We therefore expect price to continue moving in its initial direction after that small pause in the market. This was further confirmed when RSI  indicator crossed over above the 50 indicating a strong uptrend ahead which we realied on for our entry confirmation as marked on the chart.

Trading divergences when using a stochastic oscillator

The Stochastic oscillator consists of two lines which interact frequently between each other. It also shows over bought and over sold conditions.  The Stochastic indicator works the same way as the RSI indicators and are only defferetiated by flactuation levels and formation. It can also be used to identify divergences in the market.

 To find a divergence between price action and Stochastic, you have to look for disagreements between the price direction and Stochastics tops or bottoms. It acts the same way as with the MACD and RSI.

The chart below shows how to trade divergences using the stochastic oscillator. Take a look

From the above  chart price action made a lower high from A to B and at the same time the indicator achieved a higher high form A to B. This shows a disagreement between the price action and the stochastic indicator. Which calls for a divergence signal.

Since the stochastic indicator closed its high in the over bought zone, this means that AUD/NZD has been overbought therefore we should expect a future price fall.

When the stochastic lines crossover within the overbought zone pointing down, it gives a strong signal confirmation that we should short the pair.  A strong downtrend movement is likely to occur after the cross below the over bought zone.

Carefully study the chart above.

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