Divergence is one of the most popular ways to use indicators and identify trend reversals. How does it work and what are the crucial things to consider?
In a trading strategy, there are many factors that come into play. Apart from fundamentals, traders can also use a number of indicators to find out what might happen to the price in the future. Using indicators is considered relatively simple because it only involves recognizing patterns from the past price action and predicting where the trend will move. Thus, it can be used by various types of traders regardless of their level of expertise.
Although there are traders that criticize indicators for their lagging nature, it is actually pretty practical to help us find good trade entries. One of the most popular uses of indicators is the divergence strategy.
Divergences are great for figuring out the trend's strength and indicating a trend reversal. Therefore, this strategy is suitable for counter-trend traders to determine good trading opportunities. Here, we will explore the facts about divergence and how it can tell you about the direction of a trend.
What is Divergence?
Before we jump into the actual method, it's essential to define the divergence strategy first.
A divergence occurs when the indicator and price action that you're using is out of sync. One of the possible scenarios is when the price makes a higher high, but your indicator makes a lower high. Such condition indicates that something is about to happen that requires your attention, though it may not look obvious at first glance. In a nutshell, a divergence exists when your indicator does not "agree" with the current price action.
Theoretically, prices and indicators are supposed to go in the same direction at equal rates. If the price happens to reach a higher high, then the indicator is supposed to move in a similar manner. The same condition applies to lower highs, lower lows, and higher lows. So if the price and the associated indicator don't correlate, then you can tell that a divergence has formed and there might be a change coming up.
See Also: How to Know When a Trend is Ending
Moreover, a divergence can signal a positive or negative price move. Positive divergence occurs when the price makes a new low but the indicator starts to climb. Meanwhile, a negative divergence happens when the price makes a new high but the indicator goes down. Such information would be helpful to see if there's a trend change, as well as determine whether you want to enter, exit the trade, or set a new stop loss.
However, it's also crucial to note that like most technical analyses, using divergence alone may not be enough. Not all price reversals are indicated by divergence and when divergence does occur, it doesn't always mean that the price will reverse anytime soon. Divergence can last for a long time, so acting on it alone is quite risky. Therefore, it's best to use a combination of several indicators and analysis techniques to confirm a trend reversal before taking any action.
Using RSI Indicator
Essentially, divergence works in any indicator, but some of the best indicators to use in divergence trading are RSI, Stochastics, MACD, and Trade Volume. In this case, we're going to use the Relative Strength Index (RSI).
The RSI indicator basically compares the average gain and loss over a certain period. For instance, if your RSI is set to 15, it means that the indicator will compare the bullish and bearish candles over the past 15 candles.
During trends, RSI can be used to compare individual trend waves to determine the strength of the trend . The following are the three possible scenarios to consider:
- Usually, the RSI makes higher highs during healthy and strong bullish trends. It means that there were more and bigger bullish candles in the recent trend wave compared to the previous wave.
- When the indicator makes similar highs during an uptrend, it means that the momentum is most likely to stay unchanged. When the RSI makes an equal high, it does not qualify as divergence because it just means that the trend's strength is steady.
- If the price makes a higher high during a bullish trend but your RSI makes a lower high, it means that the most recent bullish candles are not as strong as the previous price action and the trend is losing momentum. This is what we call a divergence.
Tips on Divergence Trading
As we have mentioned before, the occurrence of divergence does not always mean a strong reversal. Oftentimes, price enters a sideways consolidation after a divergence is formed. Bear in mind that a divergence only signals a loss of momentum, but does not necessarily identify a complete trend shift every single time.
To avoid misinterpreting the divergence, you should follow some of these tips:
Consider the Location
Location is an important factor in many trading strategies. Adding the filter of location can enhance the quality of your signals and trades. So instead of taking trades only based on a divergence signal, you can check and wait until the price moves into the previous support/resistance zone. Only then you can look for divergences and trend shifts to determine your entry point. A divergence occurring at a key support or resistance level is proven to be able to signal a stronger trend reversal.
Divergence Only Happens in 4 Different Price Scenarios
In order for the divergence to work, you must start somewhere and specify what you're looking for on the chart. It means, focusing only on the necessary things and ignore the rest. One of the key rules in divergence strategy is that in order to make a divergence, the price must form one of the following scenarios:
- Higher high than the previous high
- Lower low than the previous low
- Double top
- Double bottom
If none of these four price scenarios happened, don't even bother to consider the movement.
Draw a Line on the Top or Bottom
Now take a look at the price action. Remember, there are only four things that matter and only one of them can occur every time: a higher high, a flat high, a lower low, and a flat low.
Once you found the spot, the next step would be to draw a line backward from that high or low point to the previous high or low. Keep in mind that it has to be on successive major tops or bottom. This is the area that you should be focusing on, so if you see little bumps or dips between the two major highs or lows, you can just ignore it.
Another important note is to be consistent with your lines. If you draw a line connecting the two highs on the price action, you must also make a line that connects the two highs on the indicator you use. The same goes for lines connecting the lows.
Maintain a Vertical Position
When you observe the price chart, always make sure that the movement on the price action is aligned vertically with the indicator. Remember that the price and action and indicator should be in sync, so it's important to make sure that you're looking at the same price movement on both windows.
Watch the Slopes
While the setup of the price action and the indicator must be the same, but the actual line movement must be different for a divergence to occur. So that means, a divergence only occurs when the slope of the line connecting the indicator is different from the slope connecting the price.
The easiest way to spot divergence is by looking at the slope or the direction of the line that you've drawn. The slope can either be ascending (rising), descending (falling), or flat.
Don't Be Late!
The best way to trade divergence is as soon as it happens. If you spot a divergence but the price has already reversed and moved in one direction for some time, the divergence should be considered played out. And if the divergence is already played out, that means you're late to the party. Instead of chasing the divergence and risk your trade, it's wiser to wait for another swing high or low to form and start your divergence search over.
Use Higher Time Frames
The divergence strategy works better in higher time frames because they give you more information to work with. As a result, you will get fewer false signals and increase your chance at winning. Our best recommendation to trade divergence would be to use the 1-hour chart or higher.
See Also: Daily Time Frame Saves Your Life
You can actually use shorter time frames such as the 15-minutes chart, but keep in mind that the accuracy can be less reliable although the divergences may occur more frequently.
Divergence is a great way to analyze the chart by using technical indicators. Alongside the support and resistance strategies, finding divergence can be used to improve your analytical skill as well as improve your trading outcome. However, like all trading strategies, using the divergence method is not free of risk.
No matter how powerful your indicator is, you still need to carefully protect yourself from the risk of speculation. While this strategy is simple in practice, it takes experience to master it fully. Always be careful when using this method, and make sure to do proper backtesting and combine it with other tools to confirm the signal before deciding to take action.