Divergence Trading

Divergence trading is one of the ways to trade the market. Though divergence trading is not often used but if used correctly it can be highly profitable. Divergences are often used as important trading signals. But it doesn’t mean that divergences will always predict a reversal correctly. Price oscillator divergences have long been acknowledged by technical traders as a solid indicator of potential price reversals. Well defined divergences particularly on the long term charts can be surprisingly accurate in many instances.

Have you used divergence before in your trading? In case no than let’s me illustrate what a divergence is. Price divergence oscillators can be spotted with just two elements on the price charts. Catching a major price reversal at the correct time can be so profitable that only a few accurate divergence signals are needed to offset the inevitable false signals.

How do you determine a divergence? There are two elements in a divergence. The first element is the price and the second element is an oscillator that runs either above or below a price level. This second element can be Stochastics, RSI, MACD or any similar oscillator.

Many traders use Moving Average Convergence Divergence (MACD- pronounced McDee) as their sole confirming indicator. The MACD is among the most popular technical indicator or an oscillator invented.

MACD acts as a sign of trend momentum by representing the relationship between two moving averages. MACD is a multifaceted indicator. Some traders also take trading signals exclusively from MACD.

You must have used MACD in your trading. MACD is basically the difference between two moving averages. MACD can be traded by taking signals from the crossovers of two lines, crosses above and below the zero line. Relative Strength Indicator (RSI) is another popular oscillator that provides a measure of price momentum.

RSI is an indicator that gives overbought and oversold signals in ranging markets. RSI may also be used for divergence purposes. However, its usefulness like most other indicators tends to diminish during a trending market. Stochastic indicator may also be used for divergence trading.

Technically speaking what is a divergence? When there is an imbalance between the price element and the oscillator element a divergence occurs. This is the point when the oscillator is providing a strong hint that price may be losing its momentum and a change in price direction may therefore be impending. Both the price action and the oscillator begin to go separate ways and start telling opposite stories.

There are two types of divergences. A bearish divergence occurs when the price hits a higher high while the oscillator hits a lower high. A bearish divergence is a hint for an impending reversal back down.

What does a bearish divergence means? It is an indication that price may soon turn and go back down as the higher high in the price may lose its momentum and begin falling in case of a bearish divergence.

A bullish divergence is an exact opposite of the bearish divergence. A bullish divergence occurs when price hits a lower low while the oscillator hits a corresponding higher low. A bullish divergence hints at an impending reversal back up.

Divergences can be a remarkably effective method for helping to time major market events when used in conjunction with other trading tools. Divergences are often used as hints of possible turns and reversals. However, divergences are not frequently used as a full fledged self sufficient trading strategy.