Divergence is a term used to describe the visual disagreement between the actual price on a chart and a technical indicator. This disagreement can be seen on any time frame and often happens numerous times per day, providing opportunities for successful trading. The concept is simple, although many will also argue that the effectiveness of divergence is down to the thousands of traders who act on this signal. It can be learnt by any trader, but the ability to spot genuine divergence is a skill which is acquired through practice and close observation of the market. It is rarely used alone but it is often used as a strong underlying basis for trading the forex market in a particular direction.
Regular divergence and the ability to pinpoint market reversals
Regular divergence refers to a straightforward disagreement in price and an indicator (often an oscillator such as RSI or Stochastic). When we talk of a disagreement, it means that the indicator and the actual price of the currency pair are not reflecting the same information in regards to the price-action within the market. A good example to demonstrate this would be if price of the Euro against the US dollar rallied to a new 1 hour high. Although the price chart is showing a new high, the RSI indicator is showing that this high is actually lower than the previous high. In this case there is a disagreement between the two. Although this is fairly common on the shorter time frames, if the divergence occurs when the RSI or stochastic oscillator is within its ‘overbought’ trading range (i.e. above 75 as the default overbought level), it can be considered a signal for a future reversal.
Hidden divergence as a continuation signal
Hidden divergence is also one of the most common trading signals for those traders seeking to pre-empt the general future direction of a currency market. Although, like regular divergence, it does not necessarily indicate an instant price reversal the probability of this within the near future is very high. Unlike regular divergence, hidden divergence is slightly more complicated to grasp but also relies on a disagreement between price and an indicator. As an indication of the continuation of the underlying trend, hidden divergence occurs when price doesn’t reach a new high or low but the indicator insists that it has. In this situation price may be moving higher but form a lower high to that made earlier in the day. The RSI, however, shows that the currency pair has reached a new high on the indicator thus suggesting that it is overbought even at this lower high and must continue on its trend lower. This may sound fairly complex but once a trader learns how to spot each of these they will become immediately obvious and offer excellent opportunities to trade.
How to use divergence effectively
Divergence helps to alert traders when a market reversal or continuation is due. However, it is not advisable to trade only divergence, appreciating that currencies can remain in their oversold or overbought areas for a long time before reversing. Looking historically at price charts it is clear to see that divergence really does work if the entry is time correctly. One recommended way to ensure the best possible entry is to confirm the reversal with the help of a price action trading technique such as candlestick trading. The confluence of a reversal candlestick formation alongside divergence in an overbought or oversold area is a very high probability forex trade.
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