September 07, 2017
Divergences are a great way to determine tops and bottoms of trends, and thus making the right decision on when to enter and exit a position. In this regard, divergences are actually a leading indicator of future price action!
Normally, both the price and the technical indicator should move in the same direction. A divergence in forex occurs when the price and the indicator fail to simultaneously make higher highs or lower lows, i.e. they are “diverging” one from another. You can use any indicator for spotting divergences, like the RSI, MACD, stochastic and so on.
There are two main types of divergences, a regular divergence, and a hidden divergence. Let’s explain both types in the following lines.
Regular divergences are used to spot a possible trend reversal, and can be further divided into bullish and bearish regular divergences.
A bullish divergence occurs during a downtrend, when the price makes lower lows but the indicator makes higher lows. As price and momentum should move in the same direction, if the indicator fails to make a lower low this is a sign that the trend may reverse.
The following graphic shows a regular bullish divergence.
A bearish divergence is the opposite of a bullish divergence. It forms during an uptrend, when the price makes higher highs (HH), but the indicator fails to follow the price and instead makes lower highs (LH). This is a sign that the current uptrend may reverse.
The following graphic shows a bearish divergence.
Unlike regular divergences, a hidden divergence indicates that the underlying trend may continue. Hidden divergences can also be grouped into hidden bullish divergences, and hidden bearish divergences. A hidden bullish divergence forms during an uptrend, when the price makes a higher low (HL), but the indicator makes a lower low (LL). This situation signals that the current uptrend is about to continue.
The following graphic shows a hidden bullish divergence:
A hidden bearish divergence forms during a downtrend, when the price makes a lower high (LH), but the indicator makes a higher high (HH). If you spot a hidden bearish divergence, chances are the current downtrend will continue in the future.
Here is a graphic showing a hidden bearish divergence:
How to Trade Divergences?
Now that you know what regular and hidden divergences are, let’s take a look at real life examples of using divergences in trading.
The following chart shows the GBP/JPY pair with a regular bullish divergence.
The price made lower lows, while the RSI oscillator didn’t follow the price and made higher lows instead. This is a regular bullish divergence which indicates that the downtrend is about to end. And really, the pair started a new uptrend afterwards!
The next chart shows a hidden bearish divergence, formed on the same pair.
The price made lower highs (LH), but the RSI failed to follow the price and made higher highs (HH) instead. The result is that the downtrend continued its direction.
How to avoid entering too early when trading divergences
Just like with other trading tools, you should wait for additional confirmation when trading divergences to avoid cumulating losses. Although divergences are a great tool, you can make them even more profitable if combined with the following confirmation signals:
- Wait for a crossover of MAs – when a regular bearish or bullish divergence occurs, you can wait for the moving averages to cross which gives additional security that the current trend has ended.
- Wait for the indicators to break the trendline – when plotting a trendline on the indicator itself, you can wait for the indicator to actually break the trendline before entering a long or short position based on the divergence.