Divergence Forex Strategy Explained
DIVERGENCE FOREX STRATEGY
If you check out the success rate of forex trading, you’ll likely feel discouraged, as 70%-90% of traders don’t succeed. But generating profit isn’t always easy, not only in forex. Come to think of it, even nearly 90% of startups fail. While the odds of failure are high, it’s possible to earn a fortune from forex trading.
You may be wondering — what are successful forex traders doing right that others don’t? There are no black-and-white certainties here. It could be that the traders are patient, have mastered the principles of forex trading, are not trading too aggressively, and use forex indicators in technical analysis.
Speaking of forex indicators, they utilize tools like Divergence, Moving Average (MA), Moving Average Convergence/Divergence (MACD), and Bollinger bands to forecast or measure the volatility of a market.
Today, we’ll focus on the divergence forex strategy.
DIVERGENCE FOREX STRATEGY EXPLAINED
Divergence is a tool that helps you recognize a technical imbalance between price and a momentum indicator or oscillator. Simply put, you’ll spot when the price of a currency pair moves the opposite way of a technical indicator like Stochastic, Relative Strength Indicator (RSI), and Commodity Channel Index (CCI).
Let’s say the price is moving to higher highs, but the movement of an indicator is towards the lower lows. That would create a divergence.
Under normal circumstances, you expect the currency prices and oscillator patterns to correspond and follow a similar direction. In other words, when the price on the forex chart is reaching a higher high, the technical indicator should also be moving to a higher high. The same assumption holds true when there are lower lows.
WHAT DOES DIVERGENCE TELL FOREX TRADERS?
When divergence occurs, it signals the likelihood of the current price trend weakening and beginning of a reversal. It may be a sign that traders should prepare for an impending change in price direction.
The divergence forex strategy, if used cautiously, carries a relatively small risk on your trade. Therefore, it can be significantly profitable.
Keep in mind, though, divergence doesn’t always signal that trend reversals are entirely accurate and timely. It shouldn’t be the only tool you rely on to make forex trading decisions.
Another thing worth mentioning is that it’s possible to see the oscillator and price diverge from each other for a long period without price reversals occurring.
TRADING WITH DIVERGENCE — TYPES OF DIVERGENCE FOREX STRATEGY
Divergence can indicate a positive or negative movement. If the price of a currency is on a downtrend, but the oscillator fails to follow suit, that’s a positive movement. It indicates a bullish divergence.
If the price reaches a new high while the forex indicator fails to move to the new peak, that’s a negative movement or bearish divergence.
Bullish and bearish divergences are further divided into the following types:
· Regular bullish
· Regular bearish
· Hidden bullish
· Hidden bearish
Before we explain these types of divergence, here are a few things to know.
Regular bullish and bearish are considered the ideal divergences because they offer better signals that usually indicate a potential trend reversal. You’ll come across traders referring the regular bullish and bearish as class A divergence.
But that doesn’t mean hidden divergences are not worth the attention. They are equally useful, as they are a strong predictor of trend continuation, which could be upward or downward.
As mentioned earlier, divergence may be noticed in a trend for a long period without reversals happening. That’s because these divergences hide inside a current trend.
With that in mind, let’s now explain the types of divergence in detail.
A) REGULAR BULLISH DIVERGENCE: Regular bullish is also known as positive divergence. If the price posts lower lows, but on the forex indicator, it is displaying higher lows, then that’s a regular bullish. In this situation, it signifies a potential upward change in price.
B) REGULAR BEARISH DIVERGENCE: When prices rally from a high to a new high, we may have a regular bearish divergence if the new high of the oscillator falls below the previous high. Prices reach a higher high, but the forex indicator shows a lower high. You can call this negative divergence. In this case, the price is expected to enter a downtrend.
C) HIDDEN BULLISH DIVERGENCE: With this type of divergence, the price reaches a higher low while the oscillator shows a lower low. It is essentially a positive reverse divergence. Hidden bullish divergence signifies a price uptrend.
D) HIDDEN BEARISH DIVERGENCE: The term hidden bearish and negative reverse divergence are interchangeably used. In this case, the price on the forex chart is moving to a lower high, but the oscillator displays a higher high. It signals a continuing downtrend.
HOW TO TRADE DIVERGENCE IN FOREX
Divergences don’t occur too often, but you’ll want to pay attention whenever you spot them with your forex indicators like RSI, MACD, CCI, and Stochastic. They can help you make a significant profit in forex trading.
Since divergences can serve as a leading indicator, you could get in right before a trend changes. For example, with the regular divergences, you could buy assets near a lower low or sell near the higher top. Although the price may have reached higher tops or lower bottoms, the change will not be sustained.
With technical analysis, you can spot and predict the section where the price may stop and begin to reverse.
When it comes to hidden divergences, forex traders can stay on the correct side of the current trend for an extended period. And this could mean riding trades longer, which may increase they potential profits.
As we have stated, divergences are indicators. Therefore, they are not a 100% signal that you should enter a trade. It’s not a smart idea to make decisions solely on divergences.
Always exercise caution when trading with divergences. If you’re not sure about the ideal direction to trade, it’s best to hold on to your cash. Taking no position is better than risking on a potentially shaky trade.
Not every divergence is worth trading. For instance, small divergences can occur sometimes. You shouldn’t automatically jump in with a position. Make an effort to train your eyes to detect real forex divergences.
Divergence can be a profitable forex trading strategy if used properly and cautiously. Usually, you buy when the price level is near the bottom or sell near the top. There’s a high chance of winning in forex trading with relatively low risk. While profitable, divergences are not foolproof. You’ll want to pair them with confirmation tools to swing the odds in your favor.