Therefore, using a combination of tools and analysis can help to build the probability of a certain event happening. As traders are merely dealing in probabilities and will take losing trades to try and get a winning trade, risk management should be a hallmark of any Forex divergence strategy. In the below examples we go through a Forex RSI divergence strategy to trade the three types of divergences.
Users can switch the RSI indicator for any other but still analyse the signals in the same way, making divergence trading extremely versatile. Bullish divergences are used to trade the change in direction from a downwards move to an upwards move. They occur when price cycles create a lower low and at the same time, a technical indicator is making a higher low.
In essence, the indicator is not following the price down, suggesting the move lower is weakening and losing momentum, resulting in a possible move higher. In the example above, price cycles have made a lower low, while at the same time the technical indicator - which is the Relative Strength Index RSI,6 in this example - has not followed price down and has made a higher low. Traders would take this as a sign that the sellers driving the market lower are weak, allowing the opportunity for buyers to step in and take control.
Usually, traders would combine this analysis with other technical analysis indicators or price action. Bearish divergences are used to trade the change in direction from an upwards move to a downwards move. They occur when price cycles create a higher high and at the same time, a technical indicator is making a lower high.
In essence, the indicator is not following the price up, suggesting the move higher is weakening and losing momentum, resulting in a possible move lower. In the example above, price cycles have made a higher high, while at the same time the technical indicator - which is the Relative Strength Index RSI,6 in this example - has not followed price higher and has made a lower high. Traders would take this as a sign that the buyers driving the market higher are weak, allowing the opportunity for sellers to step in and take control.
Usually, traders would combine this analysis with other technical analysis indicators. Did you know that Admirals offers an enhanced version of MetaTrader that boosts trading capabilities? You can now supercharge your MetaTrader 4 and MetaTrader 5 trading platforms with the Supreme Edition plugin completely free.
This provides you with advanced indicators and other additional features such as the correlation matrix, which enables you to view and contrast various currency pairs in real-time, or the mini trader widget - which allows you to buy or sell via a small window while you continue with everything else you need to do. Hidden or continuation divergences are used to trade the continuation of a trend and work slightly differently to bullish and bearish divergences.
In bullish hidden, or continuation divergence the technical indicator makes a lower low while the price cycles make a higher low. In essence, it is saying that while the price is higher than it was before, the indicator is lower suggesting the market is much more oversold. This could attract buyers who are looking to employ traditional types of trading strategies such as the trend following method of 'buy low, sell high' in an uptrend.
An example showing bullish hidden, continuation divergence between price cycles and the Relative Strength Index RSI, 6. In the example above, price cycles have made a higher low, while at the same time the technical indicator has moved lower, suggesting the market is much more oversold. Traders would take this as a sign that there may be very few sellers left in the market allowing buyers to drive the market back up. In bearish hidden, or continuation divergence the technical indicator makes a higher high while the price cycles make a lower high.
In essence, it is saying that while the price is lower than it was before, the indicator is higher suggesting the market is much more overbought. This could attract sellers who are looking to employ traditional types of trading strategies such as the trend following method of 'sell high, buy low' in a downtrend. An example showing bearish hidden, continuation divergence between price cycles and the Relative Strength Index RSI, 6.
In the example above, price cycles have made a lower high, while at the same time the technical indicator has moved higher, suggesting the market is much more overbought. Traders would take this as a sign that there may be very few buyers left in the market allowing sellers to drive the market back down. One of the best ways to get started is to test-drive the trading platform and practice your ideas and strategies in a virtual trading environment.
This means you can trade in a virtual trading environment until you are ready for a live account. Get started today - completely FREE - by clicking on the banner below! This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or recommendation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time.
Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks. Contact us. Start Trading. Personal Finance New Admirals Wallet. About Us. This first divergence signal was so strong that there was even a mini divergence shown in Figure 1 with dark red dotted lines within the larger divergence that helped to confirm the signal to go long.
Luckily, some of the subsequent bull run was caught as a result of spotting this very clear divergence signal early on. Anyone who caught this particular divergence play was richly rewarded with almost immediate profit gratification.
Below, we will explain the method I used to trade it. The second divergence signal seen in dark blue , which occurred between mid-December and mid-January , was not quite a textbook signal. While it is true that the contrast between the two peaks on the MACD histogram's lower high was extremely prominent, the action on price was not so much a straightforward higher high as it was just one continuous uptrend.
In other words, the price portion of this second divergence did not have a delineation that was nearly as good in its peaks as the first divergence had in its clear-cut troughs. Whether or not this imperfection in the signal was responsible for the less-than-stellar results that immediately ensued is difficult to say.
Any foreign exchange trader who tried to play this second divergence signal with a subsequent short got whipsawed about rather severely in the following days and weeks. However, exceptionally patient traders whose last stop-losses were not hit were rewarded with a near-top shorting opportunity that turned out to be almost as spectacularly lucrative as the first divergence trade.
The second divergence trade did not do much from a pip perspective. Nevertheless, a very significant top was undoubtedly signaled with this second divergence, just as a bottom was signaled with the first divergence trade. So how can we best maximize the profit potential of a divergence trade while minimizing its risks? First of all, although divergence signals may work on all timeframes, longer-term charts daily and higher usually provide better signals.
As for entries, once you find a high-probability trading opportunity on an oscillator divergence, you can scale into position using fractionally-sized trades. This allows you to avoid an overly large commitment if the divergence signal immediately turns out to be false. If the trade becomes favorable, on the other hand, you can continue to scale in until your intended trade size is reached. If momentum continues beyond that, you should hold the position until momentum slows or anything larger than a normal pullback occurs.
At the point that momentum wanes, you then scale out of the position by taking progressive profits on your fractional trades. It is pretty safe to say that there is at least some validity to oscillator divergence signals, at least in the foreign exchange market. If you look at the recent history of the major currency pairs, you will see numerous similar signals on longer-term charts like the daily , that can provide concrete evidence that divergence signals are often exceptionally useful.
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