How to use Divergence as a Forex Indicator

The scenario of Indicator Divergence (i.e., Technical Divergence) is when the price of an asset moves in the opposite direction of a technical analysis indicator or oscillator. It is recognized as a high profit opportunity. If price continues to rise and form higher peaks while the indicator or oscillator declines it signals a negative divergence. If price continues to fall and form lower lows while the indicator or oscillator rises it signals a positive divergence.

Indicator Divergence as a price consolidation pattern can be argued. This is our choice, without a better classification, to consider it as a consolidation pattern.

By itself, negative divergence tends to be slightly less reliable that an upward trend is ending or signaling a price reversal than positive divergence. With either a bullish or bearish scenario it is best to have other technical confirmations to justify a trading opportunity. For example, an Indicator Divergence that completes it formation at a significant price support or resistance area and includes a Double Top, Double Bottom or other price consolidation pattern is more desirable. Additionally, the asset’s or security’s current price should be at sufficient distance from the longer moving average lines to justify price has indeed over-extended its upward direction and should probably retrace.

As is true for all technical analysis any single confirmation should not be the only criteria to base a trade entry or exit decision. Rather, it is always suggested that multiple technical confirmations be applied.

How to use the RSI

“Do not confuse the RSI with Relative Strength. Relative Strength is a comparison as a ratio of that security’s price to a market average or average of a market index.”

The RSI is considered over-sold when its value is below 30 and over-bought when its value is above 70. Some individuals might use slightly different values, for example, 20 and 80, or 25 and 75. We like 25 and 75. These “severe” conditions are what many individuals utilize to identify trade entry opportunities. Additionally, upward trends generally trade between the RSI values of 40 and 80, while downward trends usually trade between 60 and 20.

It might help to remember the following:

“Over-sold is time to buy and over-bought is time to sell, but only if the price is right.”

Indicator Divergence Example With Consolidation Pattern and Trendline Break:

Just as trendlines are drawn onto price, trendlines can be drawn on oscillators and indicators. The chart below demonstrates negative Indicator Divergence where price does not immediately move downward with the weakening RSI. The result is an excellent price movement that is identified and confirmed before the price reversing consolidation pattern completes its development.

At the price top on the chart an excellent Head and Shoulders price consolidation pattern has formed. The neckline of this price formation is horizontal, it is price support. The RSI, however, is overbought at the formation of the left shoulder and is weakening as the Head and Shoulder pattern continues to develop. The RSI exhibits a price divergence from the horizontal neckline and price above the neckline. That is, the price remains above the neckline support while the RSI is going downward. This downward movement of the RSI confirms underlying price weakness of the Head and Shoulders Pattern.

The result is that many participants enter short trade positions after either the right shoulder completes its Rounded Top price pattern or when the neckline support price has been violated after the right shoulder. Afterwards, many exit their trades when the RSI becomes oversold (identified by “B” on the chart).

Areas designated “A” and “C” are two other points where the RSI has become oversold. Both price areas invite trade entry or exit with respect to the direction of their price trend. “A” invites trade entry into the upward trend while point “C” invites trade exit from a downward trend and early entry into the beginning of an upward price movement. It is an early entry for a long trading position since technically the downward trendline has not yet been violated by price movement. However, point “C” demonstrates a positive divergence after being over-sold. This presents an excellent bullish position entry opportunity.

There are two other Indicator Divergence areas that are on the chart below. The first is a negative indicator divergence that completes at the high price just prior to point “A”. It is undesirable to enter a short trade during an upward, however is an an excellent price area to exist an existing open long trade.

The second Indicator Divergence, is also a negative indicator divergence, that completes at the highest price area after point “C”. It accompanies a small “M” Double Top price consolidation pattern and provides a good price area to open a short trade position.

“Due to their inherent relationship, that includes at least some price history, technical analysis oscillators and indicators for trading typically lag price movement. That is, they are slightly behind current price for a security or asset. Indicator Divergence is one of few chart trading opportunities where the oscillator or indicator leads price movement.”

“The most affective use of Indicator Divergence requires trendlines to be identified on both price and the technical oscillator or technical indicator.”

Understanding Price Movement and the RSI (Relative Strength Indicator)

Aside from Indicator Divergence (and RSI Divergence) the RSI has a few other behaviors that assist in the understanding of price movement, and therefore the understanding of tade entry and trade exit. The following describes some of these behaviors:

1. When the RSI moves upward and downward and closely approximates the peaks and valleys of local price movement on the price chart it is a very good confirmation of short term price movements that can be used to enter trades especially when over-bought (short trade opportunity) or over-sold (long trade opportunity). Trade in the overall direction of the moving average lines. For example, do not open a short trade from a falling shorter moving average line if the longer moving average lines are demonstrating momentum direction is upward.

2. When price retraces after a price movement in one direction or the other observe the RSI and whether the RSI moves more distance in the direction of the price retracement relative to its movement of the larger overall price movement. For example, price had risen in the direction of the trend and the RSI went upward also: Observe the travel of the RSI during the minor price retracement. If price had retraced 33%, however the RSI retraced more than 33% it is often an indication that price has more room to travel in its overall price direction (i.e., its trend direction). A trade can be opened in the trend direction near the bottom of the retracement, however always wait and observe that price is reversing to continue its trend direction. A minor price consolidation into a moving average line, at a rising moving average line or between two rising moving average lines (long trade opportunity) or falling moving average line(s) (short trade opportunity). Be sure that longer moving average lines also confirm that momentum in the direction of a trade opportunity exists, and in the direction of the trade opportunity considered.

3. Similar to other indicators and oscillators the RSI has a parameter that adjusts the number of time periods (chart bars) to be considered in its computation. Parameter adjustments are performed to better align price movement with the movement of the oscillator or indicater, typically current price movement. It is recommended that the typical default of 13 or 14 time periods is reasonable. If it is desired to adjust this parameter then a low of 12 or a high of 16 should be considered lower and upper limits. If the RSI still does not appear to be providing reasonable information then either consider a different chart timeframe, or possibly that you have not yet obtained sufficient experience using the RSI for identification of trading opportunities.

borse-currency-exchange-trader-roomAs an alternative two Relative Strength Indicators can be attached to the same price chart. Use one RSI with a period length of 14 and the second RSI with a much longer period length, possibly 30. The RSI(30) will be used to help track much larger and longer price over-bought and over-sold conditions. The shorter RSI(14) should help to identify better price entry points into that longer price movement.

Detrended Price Oscillator Divergence

“Divergence from price is not limited to the RSI. The following chart example demonstrates price divergence using the Detrend Price Oscillator (DPO). The DPO is our faviorite ocillator for stock trading. Perform some experimentation with oscillators and indicators to determine which is best for your trading style.”

Final Trade Set-up Thoughts

1) Look for the Indicator Divergence or Oscillator Divergence on a longer timeframe chart, for example, the daily chart. Next look for trade set-ups on a shorter timeframe in the price direction dictated by the Indicator Divergence from the longer timeframe chart. This allows shorter interval trades that incorporate the price direction of the longer term chart analysis, and therefore, the greater probability of price movements resulting from the direction of larger momentum.

2) Look at Indicator Divergence on the shorter timeframe price chart, for example, the 15 minute. This trade set-up often creates stronger and longer price movements. It is for trading price swings of a longer term trend.

When looking at a one hour chart

a. The moving average lines on the one hour chart are trending opposite the direction of the M15, and

b. Price is within the longer moving average lines of the one hour chart.

Trade the direction of the moving average lines of the one hour chart. This trade set-up often creates stronger and longer price movements.

If both the M15 and H1 charts are overbought or oversold at the same time, the H4 chart’s moving averages are opposite the direction of both the M15 and H1 charts, and price is within the longer moving averages of the H4 chart, the typical resulting price movement is large.

This trading strategy works for the H1, H4 and Daily price charts.

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