What is divergence in Forex trading and how to trade?
In the Forex market, you will encounter a myriad of trading signals and indicators as a part of the technical aspect of trading. Divergence in the Forex market is a signal of technical analysis. It’s a basic early Forex signal showing the trend reversal filtering false signals, suitable for all investors. In this article, we overview in detail divergence Forex, its meaning as well as divergence day trading strategy.
Divergence Forex meaning and definition
Divergence Forex occurs when an indicator goes in the opposite direction of price. For example, when prices rise and the indicator falls from one peak, or trough to another peak, we say that there is a bearish divergence. Conversely, if the price falls and the indicator rises from a peak or trough to another peak, then we speak of a bullish divergence. In this article, we focus on divergence Forex.
Although giving good indications, divergences do not give direct entry signals. It is very often necessary to supplement the signal with another method to determine an interesting entry.
The appearance of a divergence informs us of the weakening of the current trend. Nevertheless, it is very possible that the reversal will not take effect immediately. This is the reason why we avoid trading only with divergences.
There are two types of divergences, direct divergences and hidden divergences.
Divergence Forex explained
Divergence trading is a strategy used by many Forex traders. Some use it to identify beneficial entry points, others to choose the right time to close their positions. In this tutorial, we’ll walk you through how to spot and trade these cross-functional trading trends.
Basically, a Forex divergence involves the price chart and the technical indicator (oscillator) you use to analyze the market going in opposite directions. This is the first signal for you to understand that “something” is happening on your chart.
Divergences can be bearish or bullish.
Note that when we talk about bearish divergence, we are looking at higher highs on a price chart. When we talk about bullish divergences, we are talking about bottoms.
Besides the classic divergences, there are so-called “hidden” divergences.
Let’s take a look at Forex divergence in detail.
What is the Divergence Forex signal?
A divergence Forex indicator is the manifestation of unusual behaviour between an indicator and its prices or between two correlated markets.
For example, there will be a divergence between the price of a currency pair and its indicator (RSI, macd, Stochastqiue, etc.) or between two positively correlated pairs when the price of the currency and its indicator or the two financial markets move in phase opposition during a given period of time.
A divergence between a currency pair and its indicator will be interpreted either as a risk of a correction in the prices of the currency pair or a strong upward push in prices.
We will speak of bearish divergence on a security or an index, when we expect a downward correction of the currency pair. Conversely, we will speak of bullish divergence on a security or an index when we expect a strong upward pressure on that currency pair.
If the expected corrections or strong bullish push materializes, then the divergence is said to be corrected.
The importance of divergences is essential in trading because this technical analysis tool makes it possible to anticipate a movement in both directions of the trend well before it occurs.
Types of Divergences Forex patterns
Bullish divergences
A bullish divergence occurs when the price trend is bearish, and the indicator indicates an increase from its lows.
To identify a bullish divergence, simply compare the low points of the price curve with those of the indicator.
If the price of the asset studied falls and the indicator progresses , then we are in the presence of a bullish divergence, there is a probability strong for the trend to reverse
Bearish divergences
A bearish divergence is materialized when the price trend is bullish while the indicator indicates the opposite.
The indicator no longer makes new highs while prices still have them.
To identify a bearish divergence, simply compare the high points of the price curve with those of the indicator.
If the price of the analyzed security progresses and the indicator falls , then we are in the presence of a bearish divergence, there is a strong probability that the trend is turning.
The Hidden Bullish Divergence
A hidden bullish divergence appears during an uptrend in price when the indicator makes new lows while prices manage to make new highs.
This confirms the fact that the uptrend is powerful.
To identify a bullish divergence, simply compare the low points of the price curve with those of the indicator.
If the price of the asset studied is progressing and the indicator is falling , then we are in the presence of a hidden bullish divergence, there is a high probability that the uptrend will continue, as you can see in the example below, this is called a continuation pattern.
The Hidden Bearish Divergence
Hidden bearish divergence is materialized during a downtrend in price when the indicator makes new highs while prices make lower highs.
This confirms the fact that the downtrend is powerful.
If the price of the security analyzed falls and the indicator progresses, then we are in the presence of a hidden bearish divergence, there is a strong probability for the downtrend to continue, as you can see in the example below, this is called a continuation pattern.
How to Trade with Forex Divergence
For Forex divergence trading, you need to include one of these oscillators on your chart: the stochastic, the relative strength index (RSI) or the “convergence-divergence” moving average (MACD).
Whichever indicator you choose, we recommend that you always place Stop Loss orders before you trade. It is no different when trading divergences. You can put a Stop Loss above the last peak of the chart, which confirms the presence of a bearish divergence. If the divergence you identify is bullish, you should place a Stop Loss below the last low in the chart.
In order to find where to place a Take Profit order, you will probably need an additional indicator (especially if you are trading with RSI and Stochastics). You can use swing analysis or support/resistance levels to set a Take Profit order.
However, if you prefer to use the MACD when trading divergences, you can completely rely on this indicator without the need for any other additional trading tools. When the MACD histogram crosses the signal line from high to low, it is a signal to close the bullish position. When the MACD histogram crosses the signal line from bottom to top, it is a signal to close the bearish position.
Advantages and disadvantages of the Divergence Forex signal
The advantages of the Forex Divergences signal
The main advantage of divergence comes from the fact that it is not a lagging indicator like most indicators in technical analysis.
Indeed, just like the price evolution of an asset due to its “non-lagging indicator” aspect, the analysis of divergences is a very powerful and very useful method which makes it possible to predict the future behaviour of prices based on the evolution of the prices of the asset studied.
It is the opposite of a lagging indicator because, by definition, this type of figure always follows the evolution of the price of the security analyzed in parallel.
The price of an asset always gives the most recent information.
Divergence is a pattern that is usually associated with increased levels of volatility, as the price of an asset can only diverge so much before it experiences a large price swing and breaks down. Adjusts to what the market believes it “should” be worth.
Increased volatility creates more profitable trading opportunities over a given trading period.
By paying attention to instances of high divergence, you can capture unique trading opportunities that you may not have noticed before.
Disadvantages of the Divergences signal
The disadvantage of this graphic configuration is that despite the relevance of its indications, the divergences do not really give entry signals that can be directly exploited.
Indeed, it is often necessary to complete the signal given by this type of chart using another technical indicator that will allow us to identify an interesting entry signal.
Generally, the appearance of a divergence makes it possible to identify the weakening of the current trend and suggests a probable reversal of the trend to come.
The timing of a possible price reversal is difficult to discern, and this makes it a sensitive indicator with which it is dangerous to trade solely on the basis of the recognition of divergences.
Conclusion
Divergence in the Forex market is a signal of technical analysis. It’s a basic early Forex signal showing the trend reversal filtering false signals, suitable for all investors. Forex divergence is one of the most common trading signals used by many traders today and mostly only on the Forex market. We hope this article helped you to grasp its ins and outs in order to use it in your Forex day trading strategy.
