Today we will talk about divergences. Trading is based on price movements. It is important to be able to identify the trend. It can be quite strong sometimes. But the other times it is not. Many traders ask what to do then. The answer is to look for divergences. They can be very helpful when there is no solid trend noticeable.
Contents
The basics of divergence
The divergence can be observed with the help of the oscillators. There are many indicators of this type and they all work in the pretty same way. Naturally, there are differences between one and the other, but the principles remain the same.
Following the trend is a common approach for oscillators. The trend identification may be done through the drawing trend line, analysis of numerous timeframes, or using moving averages. The convergence is showing how strong the trend is.
We can talk about convergence when the price and the oscillator are moving in the same direction. There is also the convergence when the price action and the oscillator form peaks at the same moment and after that, they make another one higher than the first one. This gives information that the trend is gaining strength and will most likely continue in the previous direction. The same applies to the lows during the downtrend.
Now, we can tell there is a divergence when only the price action forms the second, higher (or lower) peak. That is when the price creates the second higher peak, the oscillator forms a lower one. Or when the price makes the second lower peak during the downtrend, the oscillator creates a higher one. These are the signs of the trend getting weaker and the most probable scenario is it would reverse.
Different kinds of oscillators
As I said before, you can use various oscillators. Let’s look at the most common ones.
The MACD (Moving Average Convergence Divergence) is a good choice. Just see the chart above. The price is moving down while the MACD is rising. This is the divergence and the signal of the trend reversal.
The Stochastic is behaving similarly. In our example, the price is falling, but the oscillator is going up. The reversal of the trend is imminent.
Downsides of divergences
Some of the traders claim the signals received from the divergence are weak. The thing is that the oscillator can be in fact a long time in the divergence before the trend reverses.
But the good news is that you can improve the strength of the signals by using additional price action techniques and following the candlesticks patterns. Together they can mark a good entry point during divergence under observation.
The RSI (Relative Strength Index) shows us the divergence during the uptrend. Additionally, there is a head and shoulders pattern created which can indicate a point where you should open a position.
Final word
The divergence does not happen too often. Sometimes, it is quite difficult to notice it. That is why you need practice. You need to learn about the divergence and then look for it and use it in trading. I suggest you start with a demo Olymp Trade account. You can make risk-free transactions there. This will give you time to get to know the divergence well before you risk real money. However, keep in mind that using this strategy is not a guarantee of making a profit. Just like any other strategy on the market, it has risks that you should be prepared for.
Best of luck!