- Overview of Convergence and Divergence in Forex
- Classic (Regular) Divergence in Forex trading
- Hidden Divergence
- Exaggerated Divergence
- Forex Divergence indicators
Due to the forex market's complexity, it is hard to find an optimum indicator to foresee the potential development of market trends, if any such indicator exists at all. However, forex divergence may be one of the best indicators to reveal how the market may behave in the periods to come, thereby providing the investor with the opportunity to make the best justified trading decisions. If you are interested in how to trade divergence in forex, this article is right for you.
Overview of Convergence and Divergence in Forex
Let's first define the terms convergence and divergence.
Convergence in forex describes a condition under which an asset's price and the value of another asset, index or any other related item move in the same direction. For instance, let's assume a situation in which market prices show an uptrend, and so does our technical indicator. In this case, we face continuing momentum, and there is high probability that the trend will persist. So, here, the price and the technical indicator converge (i.e. follow the same direction), and the trader may refrain from sale, as the price is likely to further grow.
Divergence in forex, to the contrary, describes a condition under which an asset's price and the value of another asset, index or any other related item move in opposite directions. For instance, if we consider again a situation where market prices grow and the technical indicator's value drops, we will face decreasing momentum, and thus signs of trend reversal. The price and the technical indicator diverge, and therefore the trader may opt for running sale for procuring the highest profit.
So, basically, forex divergence trading and convergence trading focus on the same tools and mechanisms and embrace the same actions performed by the trader for evaluating market dynamics.
When investigating more in detail the forex divergence system, it should be said that two situations may exist: upward reversal (bullish divergence) and downward reversal (bearish divergence).
Classic (Regular) Divergence in Forex trading
Classic (regular) divergence in forex trading is a situation where price action strikes higher highs or lower lows, without the oscillator doing the same. This is a major sign of the possibility that the trend is touching its end, and reversal should be expected. A forex divergence strategy is thus based on the identification of such probability of trend reversal and the subsequent analysis for revealing where and with which intensity such reversal may occur.
Classic (regular) bearish (negative) divergence is a situation in which there is a upward trend with the simultaneous achievement of higher highs by price action, which remains unconfirmed by the oscillator. Overall, this situation illustrates the weak upward trend. In those circumstances, the oscillator may either strike lower highs, or reach double or triple tops (more often true for range-bound oscillators). In case of this situation, our divergence forex strategy should be to prepare for opening a short position, as there is a signal of possible downtrend.
Classical (regular) bullish (positive) divergence assumes that in the conditions of a downtrend, price action achieves lower lows, which is unconfirmed by the oscillator. In this case, we face a weak downward trend. The oscillator may either strike higher lows or achieve double or triple bottoms (which more often occurs in range-bound indicators such as RSI). In this case, our divergence forex system strategy should be to prepare for opening a long position, as there is a signal of possible uptrend.
In contrast to classic (regular) divergence, hidden divergence exists when the oscillator reaches a higher high or lower low, while price action does not do the same. In those circumstances, the market is too weak for the ultimate reversal, and therefore a short-term correction occurs, but thereafter, the prevailing market trend resumes, and thus trend continuation occurs. Hidden divergence in forex may be either bearish or bullish.
Hidden bearish divergence is a divergence trading forex situation in which correction occurs during a downtrend, and the oscillator strikes a lower low, while price action does not do so, remaining in the phase of reaction or consolidation. This indicates a signal that the downtrend is still strong, and it is likely to resume shortly thereafter. In this case, we should either hold or open a short position.
Hidden bullish divergence is a trading divergence in forex in which correction takes place during an uptrend, and the oscillator achieves a higher high, while price action does not do so, remaining in the phase of correction or consolidation. The signal here means that the upward trend is still strong, and it is likely to resume shortly thereafter In this situation, we should either hold or open a long position.
Exaggerated divergence is overall similar to classical (regular) divergence. However, a substantial difference is the fact that the price movement pattern here forms two tops or bottoms, with the respective highs or lows located approximately on the same line. At the same time, the technical indicator shows the respective tops or bottoms in a clearly visible upward or downward direction.
Exaggerated bearish divergence is a divergence in forex is a situation in which price forms two tops approximately on the same line (with some really slight deviations possible), while the technical indicator diverges and has its second top at a lower level. In this situation, there is a continued downward trend signal, and the best option for us is either to hold or to open a new short position.
Exaggerated bullish divergence occurs when price creates two bottoms on relatively the same line, while the technical indicator diverges and has its second bottom at a higher level. In this case, we have a continued upward trend signal, and the best choice for us is to hold or open a new long position.
Forex Divergence indicators
A number of different forex divergence indicators may be used in forex divergence trading. The most common ones of them are the following:
Moving Average Convergence Divergence (MACD) is a forex divergence indicator based on the evaluation of a technical indicator's exponential moving average values for 26 and 12 days or 9 days. In divergence forex trading, the MACD histogram in a way to reveal those moments at which price does an upward or downward swing, but MACD does not do so. In fact, such situation illustrates the divergence between price and momentum. MACD is quite a straightforward and easy-to-use divergence forex indicator.
Relative Strength Index (RSI) is a divergence forex indicator which is based on the assessment of a stock's internal strength and the subsequent comparison of its upward and downward price change averages. The use of the RSI chart is similar to the use of the MACD histogram, and the main task here is to reveal the moment at which price and RSI start diverging. This may be the best divergence indicator in forex for traders able to perform basic technical analysis.
Stochastic indicator is used in divergence trading as a momentum indicator based on the evaluation of a stock's closing price and its comparison with such stock's price range over a particular period. The scheme of its use is quite the same as in the two previous indicators.
The divergence indicator in forex may be an essential tool for traders to identify signals of close market trend reversal. Through the effective use of forex divergence and convergence, to may be able to avoid possible losses and maximize your profits. Develop your own best divergence strategy of forex trading, and you will see how convenient it may be a how effectively it will fill up your trader's arsenal.