What is divergence?
The meaning of the word divergence is to move apart. In forex what divergence means is, when the price and the oscillator indicator does not agree with each other or when they move apart, then it is said to be a divergence.
How is a divergence formed?
A divergence is found by comparing the price action with the oscillator indicator. Consider the price action is moving down and creating continuous Lower Lows. So, as the indicator is developed to follow the price action, the indicator should also create Lower Low. But in the case of divergence, the indicator does not agree with the price and creates Higher Low.
What the indicator is trying to tell us is, that something in the market is not right and hence we can expect a reversal. For example. In the example shown below, the price action was making Lower low(LL), but the indicator made Higher low(HL).
So, this tells us that indicator is not agreeing with the price action, and hence, you can see the price reversed from there onwards.
Which indicators are used to find divergence?
The divergence is usually identified by using an oscillator indicator. The oscillator indicator usually consists of two levels, overbought and oversold, respectively. The upper level is of 70-80 and indicates overbought region, and the lower level is of 20-30 and indicates oversold conditions. The most commonly used oscillators for spotting divergence are
1. Relative strength index
3. MACD (moving average convergence divergence)
As per our experience with divergence, the divergence works best on RSI. So, we will first try to understand what is RSI and how does it works, and then we will learn about RSI divergence throughout this blogpost.
What is relative strength index (RSI)?
The Relative Strength Index is a momentum oscillator Indicator which calculates the strength of the price changes happening in the market to show overbought and oversold conditions. The RSI is shown as the line between two extreme levels. The overbought and oversold levels can be set anywhere between 0-100.
Understanding the indicator correctly can help you understand the concept of the divergence correctly. So, let us try to understand the RSI correctly before we move on further. Below is the example of the RSI with levels 30 and 70.
In the example above, we have the RSI installed in the trading view chart. The two blue lines in the indicator window represent the overbought and oversold levels. We have set the overbought level to 70 and oversold level to 30. The line which is following the price action and moving exactly like the price but between those two extreme levels is the RSI.
What does RSI tell you?
When the RSI line approaches the 70 levels on the indicator, it shows short term overbought levels. When the RSI line approaches the 30 levels on the indicator, it shows short term oversold region.
In the example above, you can see, as the RSI line approached the oversold level, buyers came into the market and pushed the price higher. When the RSI line approached the overbought level, sellers came into the market and pushed the market lower.
In more simpler terms the RSI gives us the short term opportunity to buy lower and sell higher. Now, that you have understood the working and use of RSI let us move on further and see the different types of divergence.
Types of divergence
These are the most used divergence and are very easy to spot. Regular divergence is found at the top and bottom of the trends, and they mostly give a reversal signal. Let us try to understand each one with examples.
1. Bullish divergence
Formation - When the market is in a downtrend and creates continuos lower lows and lower highs, a bullish divergence is formed. As the price action is creating the lower lows, the indicator should also do the same, but the indicator creates higher lows instead, and this is called a bullish divergence.
Indication - [ Bullish Reversal] The bullish divergence gives a buy signal to the traders.
In the example below, we have explained bullish divergence.
As you can see in the example above, on the USD-JPY 4-hour chart, the price was continuously moving down and creating lower lows, but when we compare it with the indicator, the indicator was making higher lows. This is called a bullish divergence. And you can see the price reversed after creating a bullish divergence.
2. Bearish divergence
Formation - When the market is in an uptrend and creates continuos higher highs and higher lows, a bearish divergence is formed. As the price action is creating the higher highs, the indicator should also do the same, but the indicator creates lower highs instead, and this is called a bearish divergence.
Indication - [Bearish Reversal] The bearish divergence gives a sell signal to the traders.
In the example below, we have explained bearish divergence.
As you can see in the example above, on the USD-JPY 4-hour chart, the price was making higher highs, but when we compare it with the indicator, the indicator was creating lower highs, this confirms a bearish divergence. And you can see after that bearish divergence, sellers entered the market and pushed the price lower.
Hidden divergence is a little hard to find and can be very tricky. Unlike regular divergence, hidden divergence is mostly used for a continuation entry. They are found in the middle of a trend.
1. Bullish divergence
Formation - When the price reverses from a downtrend and goes into an uptrend, the price starts creating higher highs. But the indicator opposes it and creates a lower high instead. This lower high, when formed at the oversold region, indicates a powerful hidden bullish divergence.
Indication - [Bullish Continuation] It gives a bullish continuation signal.
In the example below, we have shown a hidden bullish divergence.
As you can see in the example above, on the USD-JPY 4-hour chart, the price was making a higher low, but when we compare it with the indicator, the indicator was creating lower low, this confirms a hidden bullish divergence. And you can see after that hidden bullish divergence, buyers came back in the market and pushed the price higher again.
2. Bearish divergence
Formation - When the price reverses from an uptrend and goes into a downtrend, the price starts creating lower highs. But the indicator opposes it and creates a higher high instead. This higher high, when formed at the oversold region, indicates a great hidden bearish divergence.
Indication - [Bearish Continuation] It tells traders that the price will continue to move down.
In the example below, we have shown a hidden bearish divergence.
As you can see in the example above, on the USD-JPY 4-hour chart, the price after reversal started making lower highs, but the indicator, i.e., RSI is doing opposite and making a higher high. This indicates a hidden bearish divergence and tells traders that the price is going to continue moving down.
Rules for Trading Divergence
1. Wait for the completion of the candle
The number 1 rule you need to follow to trade divergence successfully is to be patient and wait for the candle confirming the divergence to form completely. Many a time it will happen to you that you will miss divergence because you didn’t position yourself on time, but it is okay.
You don’t need to make any mid candle decisions. If you miss one divergence, you will get plenty of others, and the important thing is to be present in the market. And if you make mid candle decisions, there are very high chances that you will get stopped out by the price. So, it is better to wait and be patient than to be greedy, impatient, and watch your money flush down the gutter.
2. Overbought and Oversold
Only trade the divergence which is formed above or below the two extreme levels, overbought and oversold respectively. When we trade divergence, which is formed above or below this level, it gives us a high chance of winning the trade.
Overbought and oversold levels tell us that the price is at the extreme highs and hence when a divergence is formed at these levels, we have an extra confirmation on our trade.
In the example above, you can see the price and indicator diverged above and below those two extreme levels and gave nice winning trades.
3. Divergence as an extra confirmation
Divergence is an indicator-based setup, and it should be treated as such. Only trade divergence if you have any extra confirmation, use it as an indication, not an entry trigger. Many traders make the same mistake of considering divergence as an entry signal and they jump into the trade as soon as they see a divergence.
We always tell our students that jumping into trades like this a foolish act and we are smarter, and we don’t trade like this. Forex market is full of opportunities, and it won’t matter if you miss any opportunity. You need to make sure that you don’t do anything foolish and mess up with your account.
4. Higher timeframe
This is again an important topic to talk about; many traders use smaller timeframe for trading divergence. Divergence gives a lot of false signals when traded on the smaller timeframe. Many traders use divergence for trading smaller timeframe like 1minute to 30 minutes.
But as per our opinion trading divergence on smaller timeframe gives you a lot of false signals. So, if you are a day trader try to use divergence on 1hour or higher timeframe.
5. Combine divergence with any other price action setup
Always combine a main price action strategy with divergence before trading it. Divergence, when traded alone, can make you lose a lot of money. We use divergence just as an indication, and hence when you combine it with any price action setup, we get a high winning percentage with a very little risk.
Mistakes while trading divergence
1. Mid candle decisions
The most common mistake people make while trading divergence is taking mid candle entries. We ourselves had done this a lot, years back when we were just beginners in the forex market. We used to trade divergence and while doing so most of the times made mid candle decisions. It did benefit us sometimes, but most of the times, we ended up losing money. We would feel that the divergence is about to form, and so, we would take an entry. But the divergence used to get vanished most of the times.
2. Divergence as an entry trigger
The problem with most of the traders who don’t succeed in forex trading is that they learn a good setup and consider it to be a holy grail. They think that this setup cannot ever fail and trade with this mindset. Trading with this mindset is a serious issue, and many traders go through this. Always remember, no setup is 100% correct each, and every strategy or setup fails.
The same thing happens while trading divergence; most traders use it as an entry trigger and jumps into a trade as soon as they see a divergence. When the price doesn’t go in their favor, they get angry and frustrated and thinks the market or market makers are doing this.
Treat divergence as an indication, not as an entry signal.
Divergence, when used on the smaller timeframe, gives a lot of false signals. So, trading divergence on a smaller timeframe is something which I do not recommend anyone to do. Not only divergence, but most of the indicators based setup do not give a high winning percentage when traded on lower timeframes. Avoid using smaller timeframes while trading divergence and only trade divergence on 1-hour or higher timeframe.
In the example above, you can see, a clear bullish divergence was formed on USD-JPY 15min chart.
This was a false signal, as the price didn’t respect the divergence and dropped down. This can be too frustrating because you won’t even know when to get out of the trade. As you can see, the divergence is still valid, but the price is not respecting it. So, to avoid these false signals, always trade divergence on higher timeframes.
Many traders while trading divergence gets impatient due to lack of trades and enters any setup which looks like divergence without even any confirmation.