Divergence is a popular trading technique among professional forex traders. It is often considered the domain of experts, and beginners are typically advised against exploring it. However, we will explain this trading method in an accessible way that even newcomers can understand.
Contents
- What Traders Should Consider When Analyzing Divergence
- How Divergence Forms
- Oscillator Settings and Timeframe
- How to Use Divergence
What Traders Should Consider When Analyzing Divergence
There are many divergence indicators available today, but using these analyzers alone will not bring you profit in trading if you do not have at least a basic understanding of what forex divergence is. The essence of both divergence and convergence lies in the discrepancy between the oscillator and the price chart.
Commonly used for analysis: MACD, slow Stochastic, OsMA, RSI, CCI, and similar indicators.
We will explore several methods for applying divergences, using oscillators for this purpose, as well as their settings for identifying discrepancies and analyzing signals to reduce uncertainty and complexity regarding market behavior. To start, let’s look at the classifications of divergence methods used in forex trading.
How Divergence Forms
Bullish Divergence (Buy Signal) occurs when the price forms new lows, but the indicator shows higher lows. This indicates a weakening downtrend. Usually, such a signal predicts a potential trend reversal upwards.
Example: On the EUR/USD currency pair chart, the price forms a sequence of lower lows, but the RSI begins to show higher lows. This may indicate that the bearish trend is losing strength and a reversal upwards is possible.
Bearish Divergence (Sell Signal) forms when the price creates new highs, while the indicator shows lower highs. This signals a possible weakness in the uptrend and predicts a reversal downwards.
Example: In the case of the USD/JPY pair, the price continues to make new highs, while MACD or RSI starts showing lower highs. This may indicate an upcoming correction or a reversal downwards.
Classic or Proper Forex Divergence
On the market, divergence refers to any discrepancy between price peaks or troughs and the peaks or troughs of the oscillator used in trading. In proper divergence, also known as ‘Class A Divergence’, the following is taken into account: if the price makes higher highs (peaks), but the oscillator shows lower highs (it lacks strength), this indicates a bearish divergence and signals a potential reversal of the bullish trend.
If the price makes lower lows, but the oscillator shows higher lows, this indicates a bullish divergence and signals a potential reversal of the bearish trend.
As you can see, there is nothing complicated about identifying the main and strongest divergence of Class A – everything is straightforward and easy to understand. The logic of application is quite clear and effective, as any indicator is a smoothed representation of fluctuations based on previous movements of the currency pair. Essentially, divergence helps identify what is difficult to notice with the human eye and allows entering the market as efficiently as possible.
Class B Divergence
The next type of divergence is ‘Class B’. For its identification, the following rules are used: if the price forms a double top, and the oscillator has a double top where the subsequent peak is lower than the previous one, then it is a signal of bearish divergence and we expect an upcoming bearish trend.
If the price forms double bottoms with its lows, and the oscillator has a second peak that is higher than the previous one, this is a signal of bullish divergence and we expect the start of a bullish trend.
This type of divergence is considered slightly weaker than Class A divergence, but it should not be ignored, as it often determines the start of a good trend. As you have already noticed, any divergence is a signal for a bounce (trend reversal), unlike convergence, which signals continuation of the trend.
Class C Divergence
It is considered the weakest and is recommended to be used only in rare cases when you have no other signals. It may require knowledge of trading volumes of the currency instrument for confirmation.
- Bearish Divergence: the price tells us about a new, higher high; the oscillator forms a double top with approximately equal peaks. We consider short positions.
- Bullish Divergence: the price makes a lower low than the previous one; the oscillator forms a double flat bottom. We consider long positions.
Oscillator Settings and Timeframe
No one can tell you the correct answer here. Trading on divergences, even though it is somewhat close to some fundamental data, remains a subtle follow-up to price and its formations. It still remains a probabilistic method. Of course, it points you towards some ‘catastrophes’ in the exchange rate that you can use in your trading, but it cannot explain why the price should change direction. Therefore, like any indicator strategy, you will have to test and adjust the method to historical data yourself, i.e., optimize the timeframe and oscillator settings according to history.
It is important to note that trading using divergence methods is extremely close to price and is undoubtedly a powerful tool for any professional trader, either in its pure form or in combination with a main trading strategy.
How to Use Divergence
Divergence is not an absolute signal for a trend reversal, but can be used as additional confirmation for decision-making. It is recommended to combine this method with other analysis techniques, such as support and resistance levels or candlestick patterns, to increase the accuracy of signals.
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“excerpt”: “Learn how to recognize and use divergence
FAQ
What is divergence in forex trading?
Divergence occurs when the price and an oscillator show conflicting movements, indicating potential trend reversals.
What are the types of divergence?
The main types are Class A (proper), Class B, and Class C, with Class A being the strongest and most reliable for trend reversal signals.
How should divergence be used in trading?
Divergence should be used as a confirmation tool alongside other methods like support/resistance or candlestick patterns to improve accuracy.
