In the eBook, ’13 Pro Tips for Using Chart Setups’, we talk about a range of excellent chart setups you can consider as part of your trading plan.
Today we’ll take a look more specifically at the 11th tip, which is ‘Some more damn good set-ups’ and focus specifically on divergence.
In its most basic form, divergence is when the price of the Forex pair you are watching diverges from the indicator you have on your charts.
For example, the price on the chart you are looking at has just made a new higher high, but the indicator is making a lower high. This is divergence.
The best types of indicators to use when looking for divergence are oscillators.
The most commonly used oscillators for identifying divergence include:
We use oscillators as they range between 0 and 100 and help us identify overbought and oversold levels on the chart. Below is a screenshot of all the oscillator indicators available on MT4 within the Oscillators folder.
Divergence is one of the strongest reversal signals you can get. But do keep in mind, this is a reversal trading strategy whereby you are fading the current trend.
Below is an example of bearish divergence on the British Pound (GBPSUD).
You will notice the price made a higher high, but the indicator made a lower high.
This is a classic bearish divergence signal.
But you don’t want to jump straight in and short a trending market. A smart trader will always wait for a confirmation before entering.
In this case, you want to see the price action pulling back before entering short.
If you were an end of day trader, you could wait for the price to trade below yesterday’s close.
The first example below is a strong one and occurred on the DAX index on the 3rd of May 2019.
You will see the price action was very bullish leading up to it. A few factors contributed to the impressive pullback with the largest and most recent (13th of May) being China retaliating to the increase in tariffs by the US on $200 billion worth of goods.
But the key area of focus is the breakout high on the 3rd of May with the stochastics indicator screaming divergence.
At this point, if you waited for the price action to trade below the close, you would have had a potential entry opportunity the very next day.
But it would be fair to say you would have had divergence signals for a full week before the breakout high.
This is where you need to set up rules around your entry criteria, keeping in mind that some of the most powerful divergence signals come after getting stopped out a few times before the big move.
As a result, some traders look to enter with half their normal position size when trading divergence. Then as the market moves in their direction, they look to add to their winning position by adding the other half of their full position size.
Below is another powerful bearish divergence signal on the US dollar index.
Once again, you can see the price was making a new short-term higher high while the stochastics was making a lower high.
This is often a signal that the market has run out of steam, setting up the potential for a solid risk-reward reversal trade.
Not only did the market pull back from the short-term high, but the dollar index went on to make a new short-term lower low.
For our third example, we wanted to show a signal that at best, you broke even but failing that, you likely made a loss.
Yes, it is true. Not all trades go on to make a profit.
Many trading systems have a win percentage between 30-55%.
You may have heard of The Turtle Traders?
The Turtles were some of the best traders and fund managers back in the 1980s and had a win rate closer to 30%.
Back to our bullish divergence trading signal on WTI crude oil.
You will notice the chart was making a new short-term lower low, but the stochastics oscillator was making a higher high.
This is a classic bullish divergence trading signal.
But let’s say you entered this trade long on confirmation of it moving higher once you got the signal on the 23rd of November 2018.
You likely had five jittery days where your initial position would have been in a loss situation.
Had you have held another day, you would be in a loss situation and potentially took a hit on this trade.
This is why experienced traders trading divergence often test the market with half their normal position size before getting their full position on the trade.
As mentioned in the eBook, ‘13 Pro Tips for Using Chart Setups’, point 11 suggests divergence is a damn good set-up for you to consider in your trading.
But like every trading signal, you need to test, test and then test some more. Build your confidence with a technique through testing and see if it is something you can add to your trading toolkit.
Originally published on May 30, 2019. Updated on December 9, 2019.
The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.
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