One of the most popular and simple strategies that traders use, no matter what the financial product is, are the ones that involve divergences. The thing is that when correctly identified, a divergence is showing the top of a rising trend or the bottom of a falling one and we all know by now that everyone want to sell tops and buy bottoms. Divergences are always taking into consideration an indicator and price and it is a rule of thumb that the trader or the trading decision should always stay with the indicator and not with price.
From the indicators offered by all trading platforms, no matter it is Metatrader or JForex or Ctrader, the indicators are either trend indicators or oscillators. When it comes to divergences, oscillators are the ones to be used rather than trend indicators, although the last ones can offer valuable information as well.
The main idea when trying to look for a divergence is to find a discrepancy between a series of lower-lows in the case of a bearish trend or higher highs in the case of a bullish one when it comes to price and this series should be compared with the ones that the oscillator is making. Because the oscillator is always taking into consideration more candles when compared with the actual price, the trading decision should always come from what the oscillator is showing and not from the actual price. Remember, divergences are showing a difference between the two, as one of them shows a fake move. Because of that, we always want to stay with the one that shows information based on more candles than the current one and this can only be the oscillator. To be honest, all oscillators are showing the same thing: overbought and oversold levels and divergences are to be spotted at those levels. The most popular and efficient oscillator to be used is the RSI (Relative Strength Index) and the recommended period is the 14 one. This means the oscillator is going to take into consideration the last 14 candles before plotting a value while price is always referring only to the actual level.
The RSI is traveling between 0 and 100 levels and it is considered to be oversold when market is dipping below the 20 level and overbought when market is trading above the 70 one. That is when divergences are kicking in.
As traders, we should look in a bullish trend for price to make a new high when compared with the previous one, and the RSI to confirm that high, in the sense that the oscillator is making a new high as well.
All good until now. Price should be extremely bullish while the RSI is above 70 or close to overbought level. A bearish divergence appears when price is making a new high yet again while the RSI is failing to make another high. This shows hesitation and the fact that bears are stepping in and longs should be careful while bears should start to be aggressive as well.
The same goes for a bullish divergence as well only that in this case price is making two lower lows while the RSI is failing to make a new low on the second attempt.
Despite the relative straight forward explanation of a divergence, the big dilemma rests with how to exactly trade it? It is not complicated, and a trader should take into consideration the following:
- -Wait for a series of at least two lower lows in price and the RSI but the RSI not to confirm the second low (in the case of a bullish divergence) or a series of at least two higher highs but the RSI not to confirm the second high (in the case of a bearish divergence).
- -By the time the above point appears, look for the RSI to jump above 40-45 level (in the case of a bullish divergence) or below 65-60 level in the case of a bearish divergence before going long, respectively short.
- -Stay long/short until the RSI shows another divergence in the overbought or oversold territory.
What is really important when trading divergences is the fact that the time frame that they appear are making the pattern powerful, in the sense that the bigger the time frame the more important the pattern and of course the target for the newly trade issued.
As mentioned a bit earlier, divergences are working great with oscillators and the RSI is the perfect one for the job, but there are also trend indicators that are suitable for spotting and trading divergences that form when comparing them with the real price action.
One of them is the Bollinger Band indicator, but more about how to trade with it in the next article here on the learning center on www.forexgator.com.