Divergence and convergence in Forex: concept and types

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

Would you like to learn how to trade divergence professionally? Many traders use the divergence between MACD, Stochastics, RSI and price quite successfully.

Divergence trading is critical to many profitable systems traders use.

What is a divergence?

Divergence in trading charts is that the price action is different from the reading of various indicators like MACD, Stochastic, RSI, etc. The idea is that divergence shows a decrease in momentum, which is not yet reflected in the price, but which could be an early indicator of a reversal.

The most accurate divergence is determined by such Forex technical indicators as:

• MACD;
• RSI.

Effective use of the divergence trading system can be one of the best tools to predict the situation and achieve effective trading results.

Divergence may be one of the best indicators to predict how the market may behave in the comingperiods, thereby giving the investor the opportunity to make the best informed trading decisions. So how is divergence trading done in Forex?

Review of Forex price divergence and convergence

As we have already defined above, divergence is when the price of an asset and the readings of the considered indicators move in opposite directions.

To define what a divergence is, let's use one example. Let's consider a situation where market prices are rising, while the readings of a technical indicator are falling. In this case, the trader will be faced with a decreasing momentum and, therefore, signs of a trend reversal. The price and the technical indicator diverge and therefore the trader may choose to sell for maximum profit.

Convergence

But besides the divergence of the price and the indicator, called divergence, there is also the opposite phenomenon of the market. This phenomenon, called convergence, implies, on the contrary, the convergence of the price and the reading of the selected indicator.

What is convergence? This is when the price of an asset and the indicator readings converge and move in the same direction. Convergence is a powerful indicator for all traders. Convergence, as the name suggests, is when two or more indicators or other analysis devices follow the same path.

What is convergence can be seen with an example, let's assume a situation in which market prices and a technical indicator show an uptrend. ATIn this case, traders are facing continued momentum and there is a high chance that the trend will continue. So, here the price and the technical indicator are converging (i.e. going in the same direction) and the trader can refrain from selling as the price is likely to rise.

There are some types of convergence that are most common in the Forex market.

• Indicator convergence with price action. This is the simplest of all convergences, but perhaps the most important to observe as it can influence the subsequent or opposite strategy. The convergence of the indicator with price action means that as prices move to a new level, the indicator also becomes new.
• Convergence of indicators. From time to time the indicators will converge. This usually happens within a few days and is usually referred to simply as "confirmation" as one indicator confirms another.
• Time frame convergence. Too often a good signal fails because the time frame is not taken into account. During one period of time, one trend can exceed another as one incoming wave overflows the other when the flow sticks.

Thus, Forex divergence and convergence, working as a tool of any strategy, are focused on the same tools.

The above types of convergence are not only powerful signal confirmations, but also great ways to find trades. Once a trader starts to recognize them, he will be able tofind them on any chart or time frame you choose.

When studying the system, it is necessary to identify and highlight the components of divergence.

1. Upward change – bullish divergence.
2. Downward – bearish divergence.

Regular divergence

Classic divergence (regular) in Forex trading is when the price action reaches higher highs or lower lows, but the indicator used remains the same.

This is an important sign that the trend is coming to an end and a trend reversal should be expected. Thus, the Forex divergence strategy is based on identifying such a probability of a trend change and subsequent analysis to identify where and with what intensity such a change can occur.

A classic bearish divergence is a situation in which there is an uptrend with simultaneous higher highs in price action that remains an unconfirmed oscillator.

In general, this situation illustrates a weak uptrend. Under these conditions, the oscillator can either hit lower highs or reach double or triple tops (most often this is true for indicators over a long time period). In this situation, the divergence strategy should be to prepare for opening a short position, as there is a signal of a possible downtrend.

Classic bullish divergence suggests that in a downtrend, price action makes lower lows, which is not supported by the indicator. In this case, the trader is facing a weak downtrend.

The indicator can either tread higher lows or double or triple bottom (which is more common in range related indicators like RSI). In this case, the divergent strategy in Forex should be to get ready to go long as there is a signal of a possible uptrend.

Unlike a classic divergence, hidden divergence exists when the oscillator hits a higher or lower low while the price action stays the same.

Hidden divergence

In these conditions, the market is too weak for a final reversal, and therefore a short-term correction occurs. After that, the prevailing market trend resumes and hence the trend continues. Hidden divergence in Forex can be either bearish or bullish.

Hidden bearish divergence is a trading divergence situation where a correction occurs during a downtrend and the oscillator falls to a low level while the price action does not, it remains in a reaction or consolidation phase. This indicates that the downtrend is still strong and will soon resume. In this case, you must either keep orgo short.

Hidden bullish divergence is a trading divergence in trading in which a correction occurs during an uptrend and the oscillator makes a higher high while the price action does not, remaining in a correction or consolidation phase. The signal here means that the uptrend is still strong and it is likely to resume soon. In this situation, you need to either hold or open a long position.

Exaggerated divergence

The essential difference between exaggerated and classic (regular) divergence is that here the price movement pattern forms two tops or bottoms, and the corresponding highs or lows are approximately on the same line. At the same time, the technical indicator shows the corresponding tops or bottoms in a clearly visible up or down direction.

Exaggerated bearish divergence is when price makes two tops on roughly the same line (with some really small deviations) while the technical indicator diverges and has a second top position at a lower level. In this situation, there is a continuous downtrend signal and the best option is to either hold or open a new short position.

Exaggerated bullish divergence occurs when the price makes two bottoms on the same line, while the technical indicator diverges and has a second bottom at a higher level. In this case, there is a continue signaluptrend, and the best choice is to hold or open a new long position.

As described above, there are some types of divergences in the Forex market, such as:

1. Regular divergence or, in other words, classic.
2. Hidden divergence.
3. Exaggerated divergence.

Indicators for finding divergence

Forex divergence and convergence is detected by some indicators used by many traders. The most common are:

• MACD (MACD) is a Forex divergence indicator based on the evaluation of exponential moving averages of a technical indicator for 26, 12 or 9 days. The MACD histogram reveals those moments at which the price makes an upward or downward fluctuation. In fact, this situation illustrates the divergence between price and momentum. MACD is a pretty easy to use divergence indicator.
• RSI (RSI) is a Forex divergence indicator based on assessing the internal strength of a stock and then comparing averages. Using the RSI chart is similar to using the MACD histogram, and the main task here is to identify the moment when the price and the RSI indicator start to diverge. This may be the best Forex divergence indicator for traders capable of doing basic technical analysis.
• The stochastic indicator is used in divergence trading as an indicator of the amount of movement based on an estimate of the closing price of a stock andits comparison with the price range of such a stock for a certain period. The scheme of its use is exactly the same as in the two previous indicators.

Conclusion

The Forex divergence indicator can be an important tool for traders to identify short-term trend change signals. Divergence and convergence in Forex, with their skillful and effective use, can significantly maximize profits and reduce losses. It is worth developing your own divergence strategy, and then you can see how effectively it works.

How to trade with divergence?

The charts below show some good examples of how to trade when indicators and price diverge. The key factor that separates the professional from the average trader is that the pros combine their trading strategy with divergence and other profitable trading strategies.

In all examples included in this article, bullish divergence is marked in green and bearish divergence is marked in red. The first example, the divergence of the MACD indicator, can occur between the price and the MACD line (blue) or the histogram (gray). The figure below shows several examples of how to trade MACD divergence. The first example is a bullish divergence.

A bullish pattern forms at a lower low in price while the MACD lines double bottomed. Although the harami pattern is relatively weak on its own, the combinationMACD divergences add strength to the pattern, while the harami pattern provides a laser focused focus point to trade MACD divergence.

The next two examples (above) show bearish MACD histogram divergences. First, price doubled up and the histogram made lower highs. Price then made three consecutive higher highs while the histogram made three consecutive lower highs. In both cases, bearish pictures were provided, which helped find the time.

The first two examples of bearish stochastic divergence are accompanied by engulfing candlestick patterns, which helps to select a high probability entry point. However, the last example did not have a candlestick pattern at the second or third high, so the trader may miss it.

The last chart (above) shows some examples of how to trade RSI divergence. Learning how to spend RSI divergences can be tricky. You may notice that the RSI line bounces up and down quite a bit, so it's not enough to base your RSI divergent trading on any RSI highs or lows.

A trader must ensure that the highs or lows used to diverge in the RSI correspond to different highs or lows in price. The same happens when trading MACD, Stochastics or RSI divergence, but the problem is more pronounced with RSI.

First exampleThe divergence in the chart above is a bullish RSI divergence that was followed by a bullish harami candlestick pattern. This is followed by an example of a bearish RSI divergence accompanied by a corresponding pop-up candlestick pattern.

Conclusion

Divergence and convergence in Forex are powerful tools in technical analysis. Divergence signals should only be considered as signs of trading opportunities and not as buy or sell signals in and of themselves. Professionals always combine other trading signals with divergence to gain an advantage in the market.

A successful trade is a trade that brings better trading decisions than 95% of other traders. It requires a profitable trading system, great mental discipline and impeccable money management. A divergence trading strategy for the MACD, Stochastic or RSI can provide the benefits you need.