What
if there was a low risk way to sell near the top or buy near the bottom of a
trend?
What
if you were already in a long position and you could know ahead of time the
perfect place to exit instead of watching all your unrealized gains vanish
before your eyes because your trade reverses direction?
What
if you believe a currency pair will continue to fall but would like to go short
at a better price or a less risky entry?
Well
there is a way. It’s called divergence trading.
Divergence
is basically price action measured in relationship to an oscillator indicator.
It doesn't really matter what type of oscillator you use. You can use RSI,
Stochastic, MACD, CCI, etc. etc. The great thing about divergences is that you
can use them as a leading indicator and after some practice, it’s not
too
difficult to spot.
When
traded properly, you can be consistently profitable with divergences.
The best thing about divergences is that since you’re usually buying near the
bottom or selling near the top, your risk on your trades are very small
relative to your potential reward. Cha ching!
Higher Highs and Lower Lows
Just
think “higher highs” and “lower lows”.
If
price is making highs, the oscillator should also be making higher
highs. If price is making lower lows, the oscillator should also be
making lower lows.
If
they are NOT, that means price and the oscillator are diverging from each
other. Hence the term, divergence.
There
are TWO types of divergence:
- Regular
- Hidden
Regular Divergence
A regular
divergence is used as a possible sign for a trend reversal.
If the
price is making lower lows (LL), but the oscillator is making higher
lows (HL), this is considered regular bullish divergence.
If the
price is making a higher high (HH), but the oscillator is lower
high (LH), then you have regular bearish divergence.
Hidden Divergence
A
hidden divergence is used as a possible sign for a trend continuation.
If
price is making a higher low (HL), but the oscillator is making a lower
low (LL), this is considered hidden bullish divergence.
If
price is making a lower high (LH), but the oscillator is making a higher
high (HH), then you have hidden bearish divergence.
How to Trade Divergences
Here’s
how you could trade divergences:
|
Divergence Type
|
Price
|
Oscillator
|
Trade
|
|
Regular
|
Higher High
|
Lower High
|
SELL
|
|
Regular
|
Lower Low
|
Higher Low
|
BUY
|
|
Hidden
|
Higher Low
|
Lower Low
|
BUY
|
|
Hidden
|
Lower High
|
Higher High
|
SELL
|
Divergences
act as an early warning system alerting you when the market could
reverse. For example, if bulls have steadily pushed EUR/USD higher, the
appearance of divergence between price and indicator could mean that bulls are
running out of gas and price will soon fall
Please
keep in mind that I use divergence as an indicator, not a signal
to enter a trade! It wouldn't be smart to trade basely solely on divergences as
too many false signals are given. It’s not 100% foolproof, but when used
as a setup condition and combined with additional confirmation tools, your
trades have a high probability of winning with relatively low risk.
On the
flip side, I think it is just as dangerous trade against this indicator. If
you're unsure about which direction to trade, chill out on the sidelines.
Divergences
don’t appear that often, but when they do appear, it’d behoove you to
pay attention. Regular divergences can help you collect a big chunk of profit
because you’re able to get in right when the trend changes. Hidden divergences
can help you ride a trade longer resulting in bigger-than-expected profits by
keeping you on the correct side of a trend.
The
trick is to train your eye to spot divergences when they appear AND choose the
proper divergences to trade. Just because you see a divergence, it doesn’t
necessarily mean you should automatically jump in with a position. Cherry pick
your setups and you’ll do well.