Divergence Forex is: Meaning and how to use it in trading

Divergence Forex is - Basic Understanding

Divergence forex is a signal that indicates a disagreement between price and technical indicators. This phenomenon occurs when the indicator does not confirm the price movement in the same direction, often suggesting that the current trend may be weakening or about to change.

If observed carefully, Divergence is not an unreliable tool but rather a tool that tells different stories depending on the situation. There are many types that traders can utilize to their advantage.

Main Types of Divergence Forex and How to Use Them in Trading

Type 1: Regular Divergence (General Contradiction Signal)

Regular Divergence occurs when the price trend moves strongly, but the indicator does not confirm that strength in the same direction. This signal often indicates a potential reversal (Reversal Pattern)

Bullish Divergence: Occurs at the end of a downtrend when the price makes a new low (Lower Low) but indicators like RSI do not confirm further decline and instead show signs of recovery. This indicates that the bearish momentum is weakening and the price is likely to reverse upward.

Bearish Divergence: Occurs at the end of an uptrend when the price makes a new high (Higher High) but indicators do not confirm the continuation of the rise and start showing weakening signals. This suggests that the bullish momentum is losing strength and the price may turn downward.

Type 2: Hidden Divergence (Concealed Contradiction)

Hidden Divergence differs from Regular Divergence in that it does not indicate a reversal but suggests that the current trend will continue (Continuation Pattern)

Hidden Bullish Divergence: The price makes a higher low (Higher Low) indicating a mild correction, but the indicator still shows strong signals. This suggests that the uptrend remains strong.

Hidden Bearish Divergence: The price makes a lower high (Lower High) indicating a mild correction, but the indicator continues to show strong downward signals. This indicates that the downtrend is likely to persist.

Popular Indicators for Observing Divergence

MACD (Moving Average Convergence Divergence)

MACD uses two moving average lines to generate buy and sell signals. When MACD moves positive and increases, it indicates a strong uptrend. Conversely, when MACD moves negative and decreases, it indicates a strong downtrend.

Divergence occurs when the price makes a new high or low, but MACD does not follow in the same direction.

RSI (Relative Strength Index)

RSI measures overbought (Overbought) levels at 70 and above, and oversold (Oversold) levels below 30.

When the price makes a new high but RSI does not confirm, this is a significant Divergence signal, especially when RSI is in extreme zones.

Williams Percent Range (%R)

%R is an oscillator similar to RSI, using values from 0-100 to indicate overbought and oversold conditions. Values above 80 indicate overbought, below 20 indicate oversold.

Divergence in these zones often signals a stronger potential reversal.

How to Trade with Regular Divergence

Step 1: Identify Specific Patterns

Look for high or low points with particular characteristics, such as Double Tops in an uptrend or Double Bottoms in a downtrend.

Step 2: Observe the Indicator

When the price enters overbought or oversold zones, do not rely solely on the indicator’s confirmation. If it does not confirm, that’s a Divergence signal.

Step 3: Wait for Entry Signals

Wait for clear reversal signals, such as price returning to the moving average or breaking out of a range. Then open a position in the opposite direction.

Step 4: Manage Risk

Set appropriate Stop Loss levels, not below the recent low (in an uptrend) or above the recent high (in a downtrend).

How to Trade with Hidden Divergence

Step 1: Recognize Weak Reversals

Look for points where the price swings mildly, such as Higher Low in an uptrend or Lower High in a downtrend.

Step 2: Indicator Shows Strength

Observe that the indicator still shows strong signals despite the mild correction in price.

Step 3: Continue Holding the Position

When the price breaks back in the trend’s direction, you can add to your position (if in an uptrend) or (if in a downtrend).

Step 4: Set Stop Loss at Previous Swing Point

When trading Hidden Divergence, place your Stop Loss at the previous swing point of the price.

Practical Trading Examples

Regular Bullish Divergence in Practice

When a prolonged downtrend makes new lows but RSI does not reach new lows, it signals that selling pressure is weakening. When a long green candle appears and the price breaks out of the range, it’s a good entry point to buy.

Hidden Bullish Divergence in Practice

In an uptrend, the price makes a Higher Low (higher low point) but MACD makes a Lower Low (lower low point). This indicates the uptrend is likely to continue. When the price breaks above the range, traders can add to their positions.

Cautions When Using Divergence

1. Divergence is not 100% accurate - It may require multiple signals before the price moves as expected.

2. Combine with other signals - Do not rely solely on Divergence; use it alongside support/resistance analysis or trend analysis.

3. Always set Stop Loss - Even if Divergence appears, there’s still a risk of loss.

4. Different timeframes - Divergence seen on one timeframe may not exist on another. Make decisions based on the timeframe relevant to your trading style.

Summary

Divergence forex is a useful technical tool for predicting trend reversals. Differentiating between Regular Divergence and Hidden Divergence is crucial for developing appropriate strategies, whether for reversal trading or trend following.

By studying Divergence forex and applying it correctly, along with good risk management, this tool can significantly enhance trading accuracy.