How to Trade Divergences

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How to Trade RSI Divergence

Many traders look to the RSI traditionally for its overbought and oversold levels. While using these levels can be helpful to traders, they often overlook points of divergence that is also imbedded in RSI. Divergence is a potent tool that can spot potential market reversals by comparing indicator and market direction. Below we have an example of the EURUSD turning 738 pips after concluding a 1444 pip decline on a daily chart. Could RSI help us spot the turn? To find out, let’s learn more about traditional divergence.

The word divergence itself means to separate and that is exactly what we are looking for today. Typically RSI will follow price as the EURUSD declines so will the indicator. Divergence occurs when price splits from the indicator and they begin heading in two different directions. In the example below, we can again see our daily EURUSD chart with RSI doing just that.

To begin our analysis in a downtrend, we need to compare the standing lows on the graph. In a downtrend prices should be making lower lows and that is what the EURUSD does between the June 1 st and July 24 th lows. It is important to note the dates of these lows as we need to compare the RSI indicator at the same points. Marked on the chart below, we can see RSI making a series of higher lows. This is the divergence we are looking for! Once spotted traders can then employ the strategy of their choosing while looking for price to swing against the previous trend and break to higher highs.

It is important to note that indicators can stay ov erbought and oversold for long periods of time. As with any strategy traders should be looking to employ a stop to contain their risk. One method to consider in a downtrend is to employ a stop underneath the current swing low in price.

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DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

How to Trade Divergences

As you’ve learned in the previous sections, technical indicators and price action tend to move in tandem. For instance, when stochastic starts heading lower from the overbought zone, the corresponding currency pair usually sells off. On the other hand, stochastic climbing out of the oversold area indicates that the currency pair could rally. There are instances, however, when technical indicators and price action seem to be showing different results. Traders refer to these scenarios as divergences. Divergences take place when indicators make different highs or different lows. To be specific, higher highs in price and lower highs for the technical indicator constitute a trading divergence. So does lower highs in price and higher highs for the technical indicator. Meanwhile, lower lows in price and higher lows for the technical indicator or higher lows in price and lower lows in the indicator are also divergences.

These may be a challenge to remember at first so it might be easier to group these trading divergences into two main categories: regular and hidden. A regular divergence suggests a reversal in price action. In an uptrend, price usually makes higher highs but once the technical indicator shows lower highs, it could mean that the trend is about to turn.

In a downtrend, price usually makes lower lows but once the technical indicator draws higher lows, it might be a sign that the trend is almost over.

A hidden divergence indicates that the current trend is likely to resume. In an uptrend, price usually makes higher lows but when the technical indicator starts making lower lows in a pullback, it could be a sign that the correction is over and that the previous trend could resume

In a downtrend, price tends to make lower highs but once the technical indicator draws higher highs in a retracement, it could be a signal that the pullback is over and that the previous downtrend could carry on.

Divergences tend to work better in longer-term time frames than in shorter-term ones, as trends are more visible on those charts. Aside from that, there are also some requirements that must be fulfilled before trading a valid divergence. For one, successive highs and lows must be connected. You must also make sure that the highs or lows on the price are vertically aligned with the highs or lows in the technical indicator.

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Of course there are some instances when divergence fails and you simply have to be prepared with a good risk management strategy in these cases. To lessen the odds of this happening to you though, you might want to consider a multiple time frame analysis, as discussed in the next section.

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How To Trade With Hidden Divergences Video Tutorial

Divergence is an important leading signal.

A divergence signal develops when price leads or lags the indicator.

There are 2 types of divergences. Regular and Hidden.

Regular divergence is an important trend reversal signal.

Sometime it can be a retracement instead of a trend reversal.

However hidden divergence is more important than regular divergence.

Hidden divergence is always a trend continuation signal with a higher accuracy as compared to regular divergence.

You look for hidden divergence at the end of a retracement.

Hidden divergence tells you that the trend is going to continue in the original direction now.

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