Trading Divergences In Forex

 

Forex Divergence trading is both a concept and a trading strategy that is found in almost all markets. It is an age old concept that was developed by Charles Dow and mentioned in his Dow Tenets. Dow noticed that when the Dow Jones Industrials made new highs, the Dow Transportation Index tends to make new highs as well and when the Industrials index made new lows, the transportation index would also .

What if you believe a currency pair will continue to fall but would like to short at a better price or a less risky entry? If price is making higher highs , the oscillator should also be making higher highs.

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The Divergence Trades As you can see in the dollar/yen daily chart in Figure 1, these two divergence signals occurred relatively close to each other, between the last months of .

The price and the technical indicator diverge, and therefore the trader may opt for running sale for procuring the highest profit. So, basically, forex divergence trading and convergence trading focus on the same tools and mechanisms and embrace the same actions performed by the trader for evaluating market dynamics.

When investigating more in detail the forex divergence system, it should be said that two situations may exist: Classic regular divergence in forex trading is a situation where price action strikes higher highs or lower lows, without the oscillator doing the same.

This is a major sign of the possibility that the trend is touching its end, and reversal should be expected. A forex divergence strategy is thus based on the identification of such probability of trend reversal and the subsequent analysis for revealing where and with which intensity such reversal may occur.

Classic regular bearish negative divergence is a situation in which there is a upward trend with the simultaneous achievement of higher highs by price action, which remains unconfirmed by the oscillator. Overall, this situation illustrates the weak upward trend. In those circumstances, the oscillator may either strike lower highs, or reach double or triple tops more often true for range-bound oscillators.

In case of this situation, our divergence forex strategy should be to prepare for opening a short position, as there is a signal of possible downtrend. Classical regular bullish positive divergence assumes that in the conditions of a downtrend, price action achieves lower lows, which is unconfirmed by the oscillator. In this case, we face a weak downward trend. The oscillator may either strike higher lows or achieve double or triple bottoms which more often occurs in range-bound indicators such as RSI.

In this case, our divergence forex system strategy should be to prepare for opening a long position, as there is a signal of possible uptrend. In contrast to classic regular divergence, hidden divergence exists when the oscillator reaches a higher high or lower low, while price action does not do the same.

In those circumstances, the market is too weak for the ultimate reversal, and therefore a short-term correction occurs, but thereafter, the prevailing market trend resumes, and thus trend continuation occurs.

Hidden divergence in forex may be either bearish or bullish. The Trade The second divergence signal seen in dark blue , which occurred between mid-December and mid-January , was not quite a textbook signal. While it is true that the contrast between the two peaks on the MACD histogram's lower high was extremely prominent, the action on price was not so much a straightforward higher high as it was just one continuous uptrend.

In other words, the price portion of this second divergence did not have a delineation that was nearly as good in its peaks as the first divergence had in its clear-cut troughs.

For related reading, see Peak-and-Trough Analysis. Whether or not this imperfection in the signal was responsible for the less-than-stellar results that immediately ensued is difficult to say. Any foreign exchange trader who tried to play this second divergence signal with a subsequent short got whipsawed about rather severely in the following days and weeks. However, exceptionally patient traders whose last stop-losses were not hit were rewarded with a near-top shorting opportunity that turned out to be almost as spectacularly lucrative as the first divergence trade.

The second divergence trade did not do much for from a pip perspective. Nevertheless, a very significant top was undoubtedly signaled with this second divergence, just as a bottom was signaled with the first divergence trade. To read about another trading lesson learned in hindsight, see Tales From The Trenches: Making a Winning Divergence Trade So how can we best maximize the profit potential of a divergence trade while minimizing its risks?

First of all, although divergence signals may work on all timeframes, longer-term charts daily and higher usually provide better signals. Spotting a divergence on your momentum indicator, thus, tells you that the dynamics in the trend are shifting and that, although it could still look like a real trend, a potential end of the trend could be near. I am a pure reversal trader and early-trend trades after divergences are my bread and butter trades.

A divergence does not always lead to a strong reversal and often price just enters a sideways consolidation after a divergence. Keep in mind that a divergence just signals a loss of momentum, but does not necessarily signal a complete trend shift. A divergence alone is not something that strong enough and many traders experience bad results when trading only with divergences.

Just like any trading strategy, you need to add more confluence factors to make your strategy strong. Below we see how price made 2 divergences but price never sold off. The divergences, thus, just highlighted short-term consolidation. Location is a universal concept in trading and regardless of your trading system, adding the filter of location can usually always enhance the quality of your signals and trades.

On the left side, you see an uptrend with two divergences. However, the first one completely failed and the second one resulted in a massive winner. What was the difference? Such an approach will impact your performance in a big way.

Divergences are a powerful trading concept and the trader who understands how to trade divergences in the right market context with the correct signals can create a robust method and effective way of looking at price.

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