Divergence in Forex Trading
Indicators with divergence in Forex and trading strategies have become increasingly popular in the financial markets. One reason is due to the fact that divergences are a leading indicator and can precede any changes in price action. If you want to improve your Forex strategy and learn more advanced skills, this is a great place to start. See how divergence in Forex can improve your bottom line.
Table of Contents
What is Divergence in Forex?
Divergence in Forex occurs when an asset moves in the opposite direction to a technical indicator, usually a momentum oscillator or relative strength indicator. When trading currencies, Forex divergence is typically seen as a sign that the current price direction is weakening and losing momentum, resulting in a possible change of direction.
Whether the change in direction is a simple retracement, or pullback, or the sign of a more significant trend reversal usually depends on the timeframe being traded and other technical analysis such as whether the asset is trading around historic levels of support or resistance.
Some traders may also look at convergence indications to help establish whether a move is likely to continue in its direction. However, from Forex convergence and divergence indicators, divergences are far more powerful and used more commonly. There are several types of divergences to know about:
- Bullish divergence.
- Bearish divergence.
- Bullish hidden, or continuation, divergence.
- Bearish hidden, or continuation, divergence.
Let's have a look at each one of these in the Forex divergence cheat sheet next! At this stage, it may be useful to download your free MetaTrader 4 trading platform provided by Admirals . This way you are able to follow through some of the examples yourself to practice your skills in seeing divergences in real-time.
How to Find Divergences in Forex
So, how do you detect Forex divergence? To start with, a trader needs to identify which technical indicators they will use to identify divergence. There are many different types of technical indicators that are available. The most common indicators are in the category called 'Oscillators'. In your MetaTrader 4 trading platform (it is also available in the MetaTrader 5 trading platform) there are a variety of different oscillators you can use, as shown below:
A screenshot of the Indicators -> Oscillators window in MetaTrader 4 provided by Admirals .
When traders are building their strategies and identifying which Forex divergence scanner method works best for them, it is important to know what the most commonly used indicators are. The reason for this is that the more market participants who see the same signs, or patterns develop the more behind the potential move. Out of the list above the most commonly used technical oscillators to spot divergences are:
- Commodity Channel Index
- MACD (Moving Average Convergence Divergence)
- Relative Strength Index (RSI)
- Stochastic Oscillator
- Williams Percent Range
A popular question for many traders is: How accurate is divergence trading? In answer to this, it is important to remember that technical tools are not predictive tools. They simply provide a statistical probability of one thing happening over another. Therefore, using a combination of tools and analysis can help to build the probability of a certain event happening. As traders are merely dealing in probabilities and will take losing trades to try and get a winning trade, risk management should be a hallmark of any Forex divergence strategy.
In the below examples we go through a Forex RSI divergence strategy to trade the three types of divergences. Users can switch the RSI indicator for any other but still analyse the signals in the same way, making divergence trading extremely versatile.
You can also watch the following video on How to Trade Divergence:
1. What is bullish divergence?
Bullish divergences are used to trade the change in direction from a downwards move to an upwards move. They occur when price cycles create a lower low and at the same time, a technical indicator is making a higher low. In essence, the indicator is not following the price down, suggesting the move lower is weakening and losing momentum, resulting in a possible move higher.
An example showing the bullish divergence between price cycles and the Relative Strength Index (RSI, 6).
In the example above, price cycles have made a lower low, while at the same time the technical indicator - which is the Relative Strength Index (RSI,6) in this example - has not followed price down and has made a higher low. Traders would take this as a sign that the sellers driving the market lower are weak, allowing the opportunity for buyers to step in and take control. Usually, traders would combine this analysis with other technical analysis indicators or price action.
2. What is bearish divergence?
Bearish divergences are used to trade the change in direction from an upwards move to a downwards move. They occur when price cycles create a higher high and at the same time, a technical indicator is making a lower high. In essence, the indicator is not following the price up, suggesting the move higher is weakening and losing momentum, resulting in a possible move lower.
An example showing the bearish divergence between price cycles and the Relative Strength Index (RSI, 6).
In the example above, price cycles have made a higher high, while at the same time the technical indicator - which is the Relative Strength Index (RSI,6) in this example - has not followed price higher and has made a lower high. Traders would take this as a sign that the buyers driving the market higher are weak, allowing the opportunity for sellers to step in and take control. Usually, traders would combine this analysis with other technical analysis indicators.
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3. What is bullish hidden/continuation divergence?
Hidden or continuation divergences are used to trade the continuation of a trend and work slightly differently to bullish and bearish divergences. In bullish hidden, or continuation divergence the technical indicator makes a lower low while the price cycles make a higher low.
In essence, it is saying that while the price is higher than it was before, the indicator is lower suggesting the market is much more oversold. This could attract buyers who are looking to employ traditional types of trading strategies such as the trend following method of 'buy low, sell high' in an uptrend.
An example showing bullish hidden, continuation divergence between price cycles and the Relative Strength Index (RSI, 6).
In the example above, price cycles have made a higher low, while at the same time the technical indicator has moved lower, suggesting the market is much more oversold. Traders would take this as a sign that there may be very few sellers left in the market allowing buyers to drive the market back up. Bullish hidden/continuation divergences are popular with trend-based traders and those using Forex divergence scalping strategies.
4. What is bearish hidden/continuation divergence?
In bearish hidden, or continuation divergence the technical indicator makes a higher high while the price cycles make a lower high.
In essence, it is saying that while the price is lower than it was before, the indicator is higher suggesting the market is much more overbought. This could attract sellers who are looking to employ traditional types of trading strategies such as the trend following method of 'sell high, buy low' in a downtrend.
An example showing bearish hidden, continuation divergence between price cycles and the Relative Strength Index (RSI, 6).
In the example above, price cycles have made a lower high, while at the same time the technical indicator has moved higher, suggesting the market is much more overbought. Traders would take this as a sign that there may be very few buyers left in the market allowing sellers to drive the market back down. Bearish hidden/continuation divergences are popular with trend-based traders and those using Forex divergence scalping strategies.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or recommendation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.