There
are nine cool rules for trading divergences. Learn 'em, apply 'em, and make
money. Ignore them and go broke.
1.
In
order for divergence to exist, price must have either formed one of the
following:
Higher high than the previous high
Lower low than the previous low
Double top
Double bottom
Higher high than the previous high
Lower low than the previous low
Double top
Double bottom
Don’t even bother looking at an indicator unless ONE of these four price scenarios have occurred. If not, you ain’t trading divergence buddy. You just imagining things. Immediately go see your optometrist and get some new glasses.
2.
Okay
now that you got some action (recent price action that is), look at it.
Remember, you"ll only see one of four things: a higher high, a flat high,
a lower low, or a flat low. Now draw a line backward from that high or low to
the previous high or low. It HAS to be on successive major tops/bottom. If you
see any little bumps or dips between the two major highs/lows, do what you do
when your significant other shouts at you - ignore it.
3.
Once
you see two swing highs are established, you connect the TOPS. If two lows are
made, you connect the BOTTOMS. Don’t make the mistake of trying to draw a line
at the bottom when you see two higher highs. It sounds dumb but peeps regularly
get confused.
4.
So
you’ve connected either two tops or two bottoms with a trendline. Now look at
your preferred indicator and compare it to price action. Whichever indicator
you use, remember you are comparing its TOPS or BOTTOMS. Some indicators such
as MACD or Stochastic have multiple lines all up on each other like teenagers
with raging hormones. Don’t worry about what these kids are doing.
5.
If you
drew line connecting two highs on price, you MUST draw a line connecting the
two highs on the indicator as well. Ditto for lows also. If you drew a line
connecting two lows on price, you MUST draw a line connecting two lows on the
indicator. They have to match!
6.
The
highs or lows you identify on the indicator MUST be the ones that line up
VERTICALLY with the price highs or lows.
7.
Divergence
only exists if the SLOPE of the line connecting the indicator tops/bottoms
DIFFERS from the SLOPE of the line connection price tops/bottoms. The slope
must either be: Ascending (rising) Descending (falling) Flat (flat)
8.
If you
spot divergence but price has already reversed and moved in one direction for
some time, the divergence should be considered played out. You missed the boat
this time. All you can do now is wait for another swing high/low to form and
start your divergence search over.
9.
Divergences
on longer timeframes are more accurate. You get less false signals. You will
also get less trades but your profit potential is huge. Divergences on shorter
timeframes will occur more frequently but are less reliable. I personally only
look for divergences on 1-hour charts or longer. Other traders use 15-minute
charts or even faster. On those timeframes, there’s just too much noise for my
taste so I just stay away.
Divergence Cheat Sheet
|
Type
|
Bias
|
Price
|
Oscillator
|
Description
|
Example
|
 |
Bullish
|
Lower
Low
|
Higher
Low
|
Indicates
underlying strength. Bears are exhausted.
Warning of possible trend direction change from down to up. |
 |
|
Bearish
|
Higher
High
|
Lower
High
|
Indicates
underlying weakness. Bulls are exhausted.
Warning of possible trend direction change from up to down. |
 |
|
 |
Bullish
|
Higher
Low
|
Lower
Low
|
Indicates
underlying strength. Good entry or re-entry. Occurs during retracements in an
uptrend. Nice to see during price retest of previous lows. “Buy the dips”
|
 |
|
Bearish
|
Lower
High
|
Higher
High
|
Indicates
underlying weakness. Found during retracements in a downtrend. Nice to see
during price retests of previous highs. “Sell the rallies”
|
|