Technical Analysis – Divergences in Trading
A divergence is happening when the price is compared with a technical indicator, usually an oscillator, and this one is not confirming the moving price makes. 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 being placed at the bottom of a chart and are calculated based on mathematical formulas. These are either averages of past prices and can become quite complicated, depending on the oscillator used. The bigger the period that the oscillator considers, the flatter it becomes and the information becomes useless and difficult to interpret. Therefore, a balance needs to be found between the period the oscillator considers and its outcome, if the oscillator is to be of any. 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 like the Relative Strength Index (RSI), is using the 14 periods, it means that the last fourteen candles are considered before plotting the current value of the oscillator. If the time frame is a monthly one, the last fourteen months, if it is a daily one, the last fourteen days, and so on. This is the reason why traders are saying that, if one has to choose between price and an oscillator, the oscillator’s move should be always favored.
Bullish and Bearish Divergences
Another famous saying among Forex traders is that price can stay in a diverged mode more 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 are showing overbought and oversold levels. This means that traders are buying or are inclined to buy when the price is reaching an oversold level and selling when the price is reaching overbought levels. Unfortunately, this has become a cliché lately. If trading would be that simple, everyone would make money, and the cruel reality we all know is different. Something needs to come 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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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 look for divergences is the Relative Strength Index and a bullish divergence will look like the one in the chart below. This is the AUDUSD weekly time frame and the bullish divergence here resulted in a major bottom to form.
The key in correctly interpreting a divergence is to always compare the move the price and oscillator make. They should be similar. 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. As simple as that. The example above shows the price is making two consecutive lows, but the second low is not confirmed by the oscillator. In reality, not only that is not confirmed, the oscillator is making a higher low, which is the base for a bullish divergence.
Divergences can be bearish too. Moreover, the RSI is not the only oscillator to be used to find useful divergences. The example below shows the EURUSD weekly time frame and the MACD (Moving Average Convergence Divergence) is plotted at the bottom of the chart. The idea to find a bearish divergence is the same: look for two consecutive highs the price makes while the oscillator is not confirming the second high.
The MACD histogram is not confirming 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 RSI and 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 is the same. Therefore, it is desirable to avoid using multiple oscillators on the same chart as the result will be the same like 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 price and the lower or upper Bollinger Bands lines.
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.
Recommended Further Readings
- Pending Orders Explained
– Different types of pending orders, how to set them, where to find them on the MetaTrader platform, and much more.
- Forex Market Participants
– Who is participating in the Forex market, its structure, componence, and implications of different groups.
- Trading on a Demo Account
– Explaining why trading on a demo account before going on a live one is mandatory for any serious trader.
- Types of Forex Charts
– How many types of Forex charts exist, how to interpret them, advantages and disadvantages of each type, etc.
- Basics of Technical Analysis
– What is technical analysis, why it is important and why traders are using it. Advantages over fundamental analysis are highlighted as well.
- Basics of Fundamental Analysis
– What is fundamental analysis, where to look for information that makes the market moving, advantages and disadvantages of trading based on fundamentals.
- Trend Indicators
– Explaining what trading indicators are, where to find them, and their benefits when trading Forex market based on technical analysis.
Other Educational Materials
- Support for resistance: technical analysis and intraday exchange rates Osler, C.L., 2000. .
- Forecasting foreign exchange rates using recurrent neural networks. Tenti, P., 1996. Applied Artificial Intelligence, 10(6), pp.567-582.