Trading Divergences | FXTRADING.com - International

Trading Divergences

Admin, October 1st, 2020

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What is a Divergence?
Divergences can be a useful tool for both trend-following and counter-trend traders alike. When traders speak of divergence, they are referring to how price action and momentum is not fully aligned as they are diverging away from each other. What traders would like to see is momentum confirming price action by moving in tandem with it. If momentum and prices diverge, it shows that momentum is weakening. And if momentum is weakening, it raises the potential for a retracement against the trend, or a trend reversal.

There are two basic forms of divergence a trader will look for:

  1. Bullish divergence: Price action has made a new low (lower low), but momentum has formed a higher low
  2. Bearish divergence: Price action has formed a new cycle high (higher high), but momentum has formed a lower high

Refer to our guide on trend analysis to help identify cycle highs and lows of a trend

How Can Traders Use Divergences?
Traders can use a bullish or bearish divergence to send a warning that a trend is weakening. In turn this could help them decide to tighten their stops (if in a trade) or hold-off from entering a trade, until momentum appears to be stronger and in their favour.

As divergences can be used to identify turning points in a market, it is also suitable to swing trading, mean reversion strategies and Elliott Wave analysis. But it can also help to identify when momentum is trying to realign with the dominant trend, which helps a trend trader prepare for their trend following strategy.

However, it is no holy grail. Divergences can send false signals, and there is no knowing in advance how long prices and momentum will divergence. So, as a timing tool on its own, it can be unreliable. For this reason, price action must confirm the divergence before the trader can be more confident a correction or reversal is indeed taking place.

 

Which Indicators are Used to Identify Divergences?
Momentum indicators are used to identify divergences. By default, MT4 provides five momentum indicators which can be used to identify them.

  1. Momentum
  2. RSI (Relative Strength index)
  3. Stochastic Oscillator
  4. CCI (Commodity Channel Index)
  5. MACD (Moving Average Convergence Divergence)

When visually compared, these indicators share similarities about how they define a price cycle. But they can also provide different signals and highlight different divergences. So, which one is better?

Well, here in lies the problem with indicators. As they are a manipulation of price data, the data becomes distorted in different ways depending on how the indicator is calculated. This can be both good and bad, but not such a major issue if the trader understands this – as blindly following indicators can lead to undesirable trading results.

It is not necessarily that important as to which indicator is chosen, although it is important that the trader understands the nuances of their chosen indicator to allow some form of consistency in their decision making.

It is outside the scope of this article to go into too much detail of each individual indicator, but to cover our bases with the example above we can quickly go over RSI, Stochastic and MACD indicators.

 

RSI (Relative Strength index)
As the RSI is calculated using the closing price, it should be directly compared to closing prices on that chart, as opposed to the actual high or low. This is a common error seen regularly, as many assume the swing highs are lows should be compared with the RSI, when in fact it should be the closing prices that are compared to RSI.

Whilst highs and lows can frequently identify divergences, they can sometimes miss them or identify incorrect ones

Here we have overlaid the closing price onto a regular bar chart to demonstrate how divergences can be missed or incorrectly identified if using swing highs and lows, as opposed to the closing price. Using the swing lows on the 22nd of August and 3rd of September meant the divergence was less apparent, yet the closing prices clearly show a bullish divergence had formed on AUD/USD with RSI on their respective lows.

The RSI is a ‘bounded’ indicator, which means it has been rescaled to fit within a defined boundary (0-100 in this case). It also attempts to flag overbought and oversold conditions (OBOS), and the traditional settings are 0-30 for oversold and 70-100 as overbought.

As a rule of thumb, divergences are assumed to be more reliable if they occur in the OBOS zones, and less reliable if seen between 30-70.

 

Stochastic Oscillator
Unlike RSI, the stochastic oscillator compares where the closing price sits in relation to its high and low over a given lookback period. This means that potential divergences should be directly compared with the highs and lows of price action.

The stochastic oscillator is also a bounded indicator between 0-100, although overbought is generally considered to be between 80-100 and oversold between 0-20. As it is an oscillator, overbought (OB) and oversold (OS) conditions tend to be more reliable in a sideways moving / oscillating market.

Traders are encouraged to experiment with the lookback settings of their indicator to filter out different divergences. So in this example we have compared the stochastic oscillator with two different settings

  • Faster Stochastic (top indicator)
  • Slower stochastic (bottom indicator)

  1. Since the end of June, GBP/JPY had been trending higher before moving into a sideways moving / corrective market. The slower stochastic did not highlight any obvious divergence with price action, but it did help identify overbought and oversold conditions over this period.
  2. Meanwhile, the slower stochastic was showing a bullish divergence with price action ahead of a breakout, in line with the dominant trend.

 

MACD (Moving Average Convergence Divergence)
Signals generated on MACD are generally much slower than RSI or stochastic divergences. As a rule of thumb, fewer signals over higher timeframes tends to be more reliable over the longer-term, although it really depends on the trader’s style as to whether fewer signals are an advantage or a disadvantage for their strategy.

For example, a longer-term trader may want to try and hold on to a trend as much as possible and not overreact to minor price fluctuations. Under this scenario a MACD may be the more suitable indicator. Yet a higher frequency, intraday trader who prefers to jump in and out of the markets throughout a session may want a faster moving indicator such as RSI or stochastic, with a shorter lookback period.

 

Walkthrough Analysis of a Bullish RSI Divergence


  1. AUD/JPY was in a strong downtrend with a series of lower lows and highs. RSI was also confirming price action by printing its own series of lower lows and highs.
  2. A bullish divergence appeared between RSI and price, with RSI forming a higher low (HL) whilst prices formed a new low (LL). The trader is now looking for price action to break a prior swing high to confirm the RSI divergence.
  3. However, price action formed a lower high, despite RSI printing a marginal new high. The bearish divergence is then ignored as the trend remains bearish.
  4. Another bullish divergence appears between price action and the RSI. Prices make a strong rally yet stall near the prior cycle high. The divergence is not yet confirmed. After prices pulled back from resistance, bulls regained control and price action broke to a new cycle high. The bullish divergence was then confirmed.

 

Using a Failed Divergence to Your Advantage
If price action is required to confirm a divergence, then failure for price action to confirm it can act as a trend continuation signal.

  1. EUR/AUD was in a strong downtrend, demonstrated with only minor retracements against the trend.
  2. Whilst prices continued to push lower, a bullish divergence formed with the stochastic oscillator.
  3. Prices made a weak attempt at moving higher, yet as the prior cycle high was not broken, the bullish divergence was not confirmed.
  4. Bearish momentum swiftly returned to see prices break a prior swing low. This invalidates the bullish divergence and confirms a resumption of the downtrend.

 

Summary:
So, there we have it. Divergences can be a useful tool, but only if used correctly by waiting for price action to confirm the divergence. And in doing so, a failed divergence can then become a trend continuation signal.

All momentum indicators will help highlight divergences and can often highlight the same ones. But, due to their differences in calculation, they can also disagree, miss or overstate a potential divergence.

Longer or short lookback periods increase and decrease the frequency of potential divergences. Therefore, traders are encouraged to experiment with different indicators and settings to get a better feel for how they work or see if they even work with their chosen timeframe and strategy. Ultimately, price action is King and the indicator is derived from it, so price action needs to be the confirmation tool.

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