What is Divergence in Trading?

Divergence in trading appears at the moment when the leading indicators start to diverge from the quotes chart. This divergence can be expressed in the form of a slight lag or a direct contradiction, but it will always be depending on what sentiments prevail in the market participants.

What makes divergence different from most other signals and indicators is that you can treat its signals with a high degree of confidence in different situations: when the trade is trending, during a market reversal, and when the best time to close a position is being determined

This concept is extremely difficult to use on its own because it depends on the current situation and works more as a forecast calibration tool. It works in combination with other tools, but you can create a really strong and effective strategy for trading in financial markets with it.

What is divergence and what forms it?

Before we proceed to a detailed consideration of the divergence, it is worth saying that to succeed in the financial markets, a trader needs not only to master the basics of technical analysis but also to choose the most suitable and functional trading terminal. The good news is that you do not need to spend much time searching for such a terminal and you certainly do not have to pay for its use. You can install MetaTrader 5 right now and experience all its advantages over earlier versions of this terminal. And you’ll certainly make a great choice because hundreds of thousands of traders all over the world are already using this trading platform.

So, now let’s take a closer look at the divergence.

Imagine that the price of the position falls in one powerful impulse. Let us assume that the price of the position has fallen by 5% in just a few seconds.

According to leading indicators, the position must continue to fall. This is what is happening, but the intensity of the price decline is not comparable to the first powerful impulse, everything is happening more quietly and smoothly. The market participants, of course, have noticed this fall, but they are not in a hurry to get rid of the position, they try to be cautious and figure out when it is best to return to trade.

This is when the divergence occurs: the indicators show one thing, but a completely different picture can be seen on the quote chart. It can work either way, for example:

  • currency quotes breakthrough the next highs, but the adjusted indicator does not go beyond the previous norms – a divergence occurs;
  • the prices go below the historical minimum, and the indicator keeps on the average level – it is ahead of the chart again, but already on fall;
  • the chart predicts a dizzying growth, but the players are not in a hurry to justify the predictions, and the curve is smoothly moving up – a lag on the rise, etc.

Detecting the divergence will become a very difficult task if the trader does not use the leading indicators – oscillators. For this purpose, the best tools will be Momentum, MACD, as well as RSI.

The divergence signals must be observed by an experienced trader: they warn of the danger of a market reversal which is invisible to the indicators, but evident when comparing the expectations and the movements of the quotes chart.

It is not uncommon to observe the major divergences during the very large-scale changes. In this case, the maximum values have been achieved not due to the incredible enthusiasm of the trading process participants, or due to some external events.

They indicate situations in which the extremes were broken through at the expense of traders who participate in the trend by inertia, therefore, very soon, it is quite possible to expect a movement in the opposite direction.

High volatility – the divergence between the market price of a position and its real value – in most cases is accompanied by the phenomenon of divergence. Use these signals to identify new earning opportunities and you will open up new opportunities for a steady income that are not available to investors who use only primary methods of analysis.

How to use indicator signals

By and large, you can determine the divergence using a single oscillator, which is very popular among traders. We are talking about MACD. It is a leading indicator that makes predictions based on the analysis of averages at different time intervals, so the predictions of this oscillator are highly accurate.

It is not always possible to estimate the divergence right here and now, so one should not take the prolonged divergence with the chart as a signal that it is time to enter the market at any price. It is possible to evaluate the phenomenon only in the following cases:

  • the actual price broke the previous maximum;
  • the price of the position has fallen below the previous minimum;
  • a double top was formed – a rise followed by a breach of the local minimum and a new rise of the position to the maximum;
  • double bottom: the same, but the price rises to the local maximum between two similar lows.

Traders often have to deal with the classical divergence, which signals the coming market reversal. It can be visually detected by looking at the chart: the trend lines indicate in which direction the trade will move for some time, but the trader should count on the further fall or rise. On a bull market, it is necessary to control the minimums and make predictions from them, as well as to buy assets with the expectation of their sharp and fairly rapid price growth. On a bear market, the strategy is the same, but it is vice versa: the forecast is calculated by the highs, and the best points are selected for selling positions, which will soon lose in value.

The divergence from the chart going consecutively is a double divergence. It should be considered as the appearance of a stronger signal of a possible trend reversal.

The double divergence is formed from several price limits that diverge from the impulse indicator.

Before drawing any specific conclusions, note that the presence of the double divergence signals a possible trend reversal, but it is impossible to tell when the trend will fade out.

If a trader learns to understand the mechanism of divergence, he will have a great opportunity to earn not only on a bull market but also to make a good profit when the market is in a bearish mood and a downtrend. But to do that a trader needs to identify the divergence and learn to distinguish it from a false divergence. In addition, it is very important to identify hidden divergences, which are not a signal of a trend reversal soon, but on the contrary, indicate its possible strengthening.

How to Detect Divergence Using RSI

The Relative Strength Index (RSI) is one of the most reliable and straightforward ways to detect divergence. It is used with a candlestick chart to determine the average direction of price movement on a position over a fixed period.

RSI counts periods in candles, so the set value of the indicator will indicate the number of candles of upward and downward trends, which it will compare. So, if the indicator is set to the 20 candle range and shows high values, we are talking about an uptrend, which provides the trader with excellent opportunities for good earnings even in a short time. If the values remain low, it means that bearish candles prevail, then the trader does not need to rush anywhere and does not need to make quick decisions. In this situation, it is important to act calmly and measure.

If you see a trend but are not sure which way it is going, then use RSI to refine your predictions. Events can follow one of the following paths:

  • There is a clear uptrend, but the RSI shows stable highs that do not increase over time. Traders who are learning the basics of technical analysis mistake stable RSI values for divergence from the chart, but this is a mistake. Such behavior of the indicator should be interpreted as confirmation of the strength of the trend: the position will grow for some time.
  • The indicator shows overestimated maximums. This is a positive sign, indicating a large number of candles of an uptrend – which means a strong bull market, which in the near future will rise sharply. The most noticeable rise will be before a reversal or a quiet fade.
  • The indicator shows undervalued highs. If this happens during a sharp rise in the position, we observe divergence. The low maximum indicates that the growth of the position is slowing down: the uptrend is dying down, and soon the market will turn in the opposite direction. If you’ve been waiting for the best moment to sell, it’s time to act. If you’re too late to buy and you’re thinking about going into a trend while it’s rising, give up on the idea: given the future forecast, now is the least profitable time to buy.

The convenience of RSI indicators is in the ease with which you can check any trend. To get even more benefit from RSI, make sure you know how to work with a Japanese candlestick chart.

How to Trade on Divergence?

Divergence from the chart indicates the fading of momentum, but not always the fading leads to a complete reversal. In the absence of external factors, the movement often ends with a trend consolidation.

Unless you have some important additional information, in this case, you should not act quickly, relying on the divergence alone. It is best to wait for the best time until the position reaches a support or resistance level. Thus, a pair of consecutive divergences can go one after the other, but if they occur in the middle sections of the rise, then you should not expect a market collapse. The market will fall after a divergence that appears at a high resistance level.

Watch for price and momentum divergence: if divergence is observed over several trading periods, you should prepare for a change of trend. When you set high time frames, the divergence grows, making it easier to identify and analyze. To track price and other things properly you can download exness trader app.

Another important tip: use trend lines and channels. It is these lines at the divergence that allow you to get the best idea of when you can expect the market to turn and in which direction it will turn.

Drawing conclusions

The main mistake of most traders is that they try to understand as many financial instruments as possible at the beginning of their career and start using them. Theoretically, this should benefit them, but in practice, they cannot understand which of these instruments should be used and when.

Probably, a trader will use one of the instruments, which usually gives accurate signals, but in rapidly changing market conditions this instrument will give completely inaccurate signals, which will lead the trader to make wrong decisions.

This is the advantage of divergences: they happen almost all the time, and therefore they can be used in work here and now. Experienced traders value the divergences for their stability and consider them to be the most reliable and universal analytical methods.

To make realistic forecasts with divergences in mind, it is necessary:

  • Understand trend movements, consolidations, resistance levels, etc. Without knowing how to read a chart, you will not be able to determine whether the indicators contradict the real market situation.
  • Use additional tools of technical analysis. There is no common solution: each trader makes his own set of tools based on experience and personal preferences.
  • To analyze ready-made examples. By getting used to how divergences look on the chart, you will be able to identify them faster.
  • Practice detecting divergences without risking your money. You can use a demo account for this purpose, or watch the charts even when you are not involved in the trading process.
  • In trading, rely only on the types of divergence you have learned to distinguish – and this skill must be confirmed by stable “triggers” of forecasts you have made from the outside, without risking your own money.

Many traders have avoided the concept of divergences for years because they used this tool early in their careers and made many mistakes. However, it is important for them to realize as soon as possible that major failures are due to inexperience: if you learn how to read divergences, you will find that it is the safest forecasting tool.

Also, don’t forget to keep up with the news of the financial world, and to use current financial analytics.

If a very serious event occurs on the market, it will overcome the divergence of any strength, simultaneously turning the market upside down and shocking most traders. Financial market participants need to be prepared for such situations, and then they can increase their chances of success.

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