Price market oscillators are used to identify price action, measure price momentum and at the same time can be used to generate market direction signals. However, as we try to analyze market charts, we often come across some scenarios where these oscillators tend to move in an opposite direction compared to price action movement. This kind of disagreement is known as a divergence.
A divergence forms on your chart when price makes a higher high, but the oscillator you are using makes a lower high or price makes lower low but the oscillator makes higher low. In this situation,the oscillator and price action are not in agreement.
Price and momentum always move hand in hand in the same direction,as prices make higher highs, indicators should also make higher highs and as it makes lower lows, indicators should do the same. When there is a difference in the movement of indicators and prices, then something is fishy in the market . That, would need your attention. This kind of disagreement shows a potential change in price momentum that may result to a change in trend.
Inorder to spot the divergences in the forex markets, you have to compare price movement to an oscillator movement. The most commonly used oscillators include:
Divergence trade setups can be spotted in any time frames and are easy to spot in the market. They play a good role by saving traders from false and weak reversals shown by indicators.
When trading divergences, you will be able to identify a weakening trend, potential reversal points and can tell whether the trend is likely to maintain its direction or reverse.
This helps you to determine the entry points and exit points.
If for example you were holding a position in the market and you spot a divergence in between the underlying indicator and price action, it’s a clear warning that there is a probable reversal coming next in the market. Better watch out and exit before you drain your profits out.
Divergences appear in two different types
When price action hits higher highs or lower lows when momentum oscillators are not doing the same.
Forexample when price is going to a higher high and the indicator is showing a lower high, that shows the bulls are losing momentum, we expect a fall in prices in the due time.
Or when the price is falling very kindly making lower lows but the oscillator gets slower and can only afford to make higher lows, there is a problem with the bears. They are losing momentum and the price is likely to increase.
Regular bearish divergence.
For an uptrend, if price is making higher highs and the oscillator makes lower highs, this is a regular bearish divergence. The change in momentum shows a weakness in the buyers as the oscillator strikes lower highs or starts forming fake double or triple tops. This signals a possible downtrend reversal. At this point price is likely to fall giving bears an excite mood to open short positions.
Regular bullish divergence:
This normally appears at the end of a downtrend. When price has achieved its lower lows and the oscillator fails by making higher lows, the disagreement between the two is known as a regular bullish divergence.
The bears are showing their weakness in the market and price is likely to increase following a change in momentum leading to a change in trend. As the oscillator struggles to make higher lows or false double or triple bottoms, buyers should be preparing for long positions for this might be the end of a downtrend.
This can be identified on the oscillators used in relation to the price movement. Hidden divergences are not strong reversal points. They may shift the trend for sometime and then the trend continues in its direction or cause no change at all. They also appear in two forms;
Hidden bearish divergences:
A correction appears during a downtrend as the oscillator strikes higher high and price can only afford lower high or maintains its previous point. The trend is still strong and may continue in its direction after the completion of the consolidation.
Hidden bullish divergence:
This forms during an uptrend. As the oscillators make lower lows, price only affords the higher lows or maintains its previous points for a consolidation. The trend is likely to continue after a while.
Divergence Table (Price and Oscillator)
Sometimes divergences may appear exaggerated while perfecting the technical indicator of the double or triple tops or bottoms (for technical, the last top is slightly lower than the first) by forming tops or bottoms on the same line. This signals a continued uptrend or down trend.
The exaggerated bearish divergence:
This where price forms two tops almost the at the same line but the indicator diverges and its second top is lower than the first one. It gives a signal that the downtrend is still strong and when formed at the end of an uptrend may lead to reversal. When spotted in a trend, you can either open a new short position or continue holding your short position. Let’s have a look at an example on the chart.
Exaggerated bullish divergence
Unlike the exaggerated bearish 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. It gives a signal for a strong contuation of an uptrend or a reversal when formed at the end of a downtrend. When this appears, you can either continue holding your open long position or open a new position.
How long you should hold an open position, is a personal thing for all traders. The decision is all yours. You know what your goals are as a trader, the kind of strategy you use to trade. All this starts from what you are? and What you want? If I am to answer, this...