Momentum indicators such as the Relative Strength Indicator (RSI), Stochastic oscillator and the Moving Average Convergence/divergence (MACD) indicators can be used very effectively to show traders when the market may be about to stall or reverse. Momentum can be described as the level of market sentiment behind any given market move and the ongoing battle between bulls and bears to influence the direction of the price. Momentum indicators attempt to show this through valuing the current price at any given time and showing this on a spectrum between oversold and overbought levels. Markets frequently hit areas of support and resistance and these momentum indicators help traders to establish whether the market may be likely to respond to these levels. When a market move begins to reflect lower momentum on these indicators it is likely to reverse, or at least correct, and is a good opportunity for traders to look for these contrarian opportunities to trade. Alongside being oversold or overbought these momentum indicators also have another function to represent the potential for a market reversal:
Divergence describes a situation where the price chart and the momentum indicator differ in the information that they are providing graphically to the trader. This disagreement shows that the market may not be a true reflection of the underlying momentum and may be near to reversal. Divergence can be seen on a price chart and indicator window where price rises before pulling back and moving to a higher high. Whilst on the price chart this would appear as though the market has found additional strength to move higher, the momentum indicator is representing an alternative analysis. The momentum indicator is showing that, whilst price moves higher for a second time on the chart, the indicator shows a lower second high. This can be interpreted by traders as a possibility that the market o longer has the momentum to sustain this second high and that a pullback is imminent. Whilst these instances of divergence are not recommended to be used as stand-alone trading signals, looking for additional signals to reinforce a trade can result in high probability trades. Traders can use techniques such as candlestick analysis or an additional indicator to reconfirm the reversal and look for an entry based on this.
Another form of divergence can be described as being “hidden” due to the fact that it may not be quite as obvious as classic divergence. Hidden divergence can be described as an indication of market continuation, reconfirming that the underlying trend direction is likely to be continued. This occurs when the momentum indicator can be seen to exaggerate a market move creating a more extreme reflection of what the price chart is actually demonstrating. An example of this is price moving to a higher low but the momentum indicator showing this as a lower low. The fact that the momentum of this less-powerful move lower has used more market momentum than the previous lower low suggests that the market will continue higher. Divergence in this sense will therefore reconfirm the upward trend and show that the bears driving lower are having little impact on the actual price despite having increased momentum.
Trading using both hidden and classic divergence can be very effective and straightforward to observe in across all forex markets. Whilst they can be traded on the lower timeframes, many traders prefer to use the 15 minute and higher timeframes in order for the signals provided by divergence to be the most reliable. Most traders also include at least one other trading signal to increase the probability of a successful trade.
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