Technical Analysis – Divergences in Trading

A divergence happens when the price is compared with a technical indicator, usually an oscillator, which does not confirm the move the price is making. Depending on the trend, divergences can be either bullish or bearish, calling for either longs or shorts to be opened. Oscillators are technical indicators that are placed at the bottom of a chart, and do calculations based on mathematical formulas. These are based on averages of past prices, and can become quite complicated, depending on the oscillator used. The longer the period that the oscillator considers, the flatter it becomes and the more useless and difficult to interpret the information becomes. A balance therefore needs to be found between the period the oscillator considers and its outcome, if the oscillator is to be of any use. By the period to be considered, in the case of the candlestick charts we’re talking about the number of candles involved. For example, if an oscillator such as the Relative Strength Index (RSI) is using 14 periods, it means that the last 14 candles are considered before plotting the current value of the oscillator. If the timeframe is a monthly one, the last 14 months are considered, and if it is a daily one, the last 14 days, etc. This is the reason why traders say that if one has to choose between the real price and an oscillator, the oscillator’s move should always be favoured.

Bullish and Bearish Divergences

Another famous saying among Forex traders is that price can stay in a diverged mode longer than the trader can stay solvent. This is so true! A divergence doesn’t mean that traders should go and trade straight away! Caution is needed, and confirmation as well. Usually, oscillators show overbought and oversold levels. This means that traders buy, or are inclined to buy, when the price reaches an oversold level, and sell when the price reaches overbought levels. Unfortunately, this has become a cliché lately. If only trading were that simple, everyone would make money, yet we all know that the cruel reality  is different. Something needs to come along and help to make mistakes in such a case, and divergences are the missing ingredient. Depending on the trend, they can be bullish or bearish.

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Bullish Divergences

A bullish divergence calls for long trades to be taken, as the trend is about to reverse. This is what a bullish divergence is: a reversal pattern. The classical indicator to use to look for divergences is the Relative Strength Index (RSI). A bullish divergence will look like the one in the chart below. This is the AUD/USD weekly timeframe, and the bullish divergence here resulted in a major bottom forming.
divergences 1
The key to correctly interpreting a divergence is to always compare the moves the price and the oscillator make. They should be similar, but when something is different, a divergence is in place: the oscillator and the price are diverging. Because the oscillator considers more candles to plot the actual value corresponding to the current price action, traders should stick with the oscillator’s move. It’s as simple as that. The example above shows that the price makes two consecutive lows, but the second low is not confirmed by the oscillator. In reality, not only  is it not confirmed, but the oscillator makes a higher low, which is the basis for a bullish divergence.

Bearish Divergences

Divergences can be bearish too. The RSI is not the only oscillator to be used to find useful divergences. The example below shows the EUR/USD weekly timeframe with the Moving Average Convergence Divergence (MACD) plotted at the bottom of the chart. The way to find a bearish divergence is the same: look for two consecutive highs made by the price where the oscillator does not confirm the second high.
divergences 2
The MACD histogram does not confirm the second high, and that is a sign of weakness, or a sign that the bullish trend is going to end. The signal line (the red line) with the indicator is used as the actual entry point for a short trend. Besides the RSI and the MACD, there are other oscillators (as a matter of fact, almost all oscillators allow for divergences to be found) that can be used: the Momentum oscillator, the Relative Vigor Index (RVI), the Stochastics oscillator, etc. The principle, however, is the same, and, if applied on the same chart, the signal will be the same.

It is therefore desirable to avoid using multiple oscillators on the same chart, as the result will be the same as using a single one. What traders don’t know, or few know, is the fact that divergences can form with trend indicators as well!

Divergences with Trend Indicators

The indicator to be used in this case is the Bollinger Bands. This is one of the most famous trend indicators, and the idea is, again, to look for differences between the price and the lower or upper Bollinger Bands lines.
divergences 3
The chart above shows a bullish divergence that formed when the lower Bollinger band did not confirm the two lows the price made. As a result, a bounce followed, and longs could have been traded.

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