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All you were afraid to ask about divergence in forex

Hello, comrades traders! People often ask me: does technical analysis work? What is the best forex indicator?

There is no better indicator. But if I was offered to choose only one element of forex technical analysis, which carries the greatest power, then I would choose divergence.

What is divergence?

You must be wondering what divergence is? Perhaps you are aware, or you must be one of the few who really know what this signal is. Divergence is an early sign of how the market will behave in the near future. At the moment of its reversal, the market, as a rule, reaches its peak and lets us know that it no longer has the strength necessary to continue its movement in the same direction.

As an interpretation of this term, the dictionary provides a short list of the following related words:
Change of direction, deviation, divergence and disagreement.

During trading in the forex market, a divergence phenomenon emerges, which is displayed in the following: "the direction of the indicator is at variance with the direction of the price movement".

To a greater extent, this phenomenon is reflected by indicators such as MACD, Stochastic Oscillator and RSI. You can also see divergence on other indicators that you would never even think about that they can display it.

As you know, the market moves up and down, even in a trend. The oscillator strictly follows the price movement. If the market moves up, the oscillator also moves up. When the market draws a higher high, the oscillator also draws a higher high.

Divergence is formed when the market shows a high maximum on the chart, and the oscillator that strictly follows it does not display a higher high, but instead draws a lower high! This clearly demonstrates the situation when the oscillator indicates that the market has weakened and that there is a high probability that a price correction (rollback) will occur in the near future, or even a market reversal.

The market makes a higher high, but the indicator draws a lower high!

Divergence in the example above is called the classic bearish divergence. We will gradually introduce new terms and their interpretation. In this example, we demonstrate to you that the indicators do not always reflect the trend on the market. And we can use this discrepancy to open a position!

A similar situation may appear in a falling market. If the market is showing lower lows, the indicator also displays lower lows. If there is a discrepancy between the price chart and the indicator, we assume a possible change in direction.

The market makes a second lower low, however, the indicator makes a higher low!

The divergence described above is called the classic bullish divergence. The term “bullish” refers to the direction of the price chart in which the market will go after divergence.

  • Bullish if the market then goes up.
  • Bearish if the market then goes down.

Different types of divergence

Earlier, we considered the possibility of trading in both types of trends using various counter-trending trading techniques. There are different types of divergences.

The most common form of divergence is counter-trend divergence. Many traders to some extent master the methods of trading against the trend. Since these techniques are so common in regular trading, this type of divergence is called classical or ordinary divergence. At the heart of other trading systems used by traders, sometimes there is the same ordinary divergence, just a trader does not comprehend its presence in it. In this guide, we will help you better understand trading techniques, and you will determine the divergence in your trading strategies, along with the application of other trading principles.

Types of divergence

1. Classical or ordinary divergence

2. Hidden divergence

3. Extended divergence

Classical divergence is the most common; it takes place in a trend reversal.

Hidden divergence is known to approximately 25% of forex traders who use regular divergence. Hidden divergence is a sign of a continuation of the trend.

Extended divergence is also a sign of the continuation of the trend. Few people know about this type of divergence. Nevertheless, it is a powerful signal that can be used in trading.

Classic divergence

Ordinary divergence is a type of divergence that portends a trend reversal in the forex market and can be a signal to open a long (buy) or short (sale) position.

  • The usual bearish divergence indicates that the price chart is going to go down, be ready for sale.
  • The usual bullish divergence indicates that the price chart is going to go up, be ready to buy.

Classic bearish divergence:

In order to identify the usual bearish divergence, we must look at the highs, or peaks, of the price chart and indicator. The usual bearish divergence occurs when the price chart draws a higher high and the indicator draws a lower high. To do this, it is not at all necessary that there is a series of higher highs on the price chart (in the market); just see one higher peak compared to the previous one. If the indicator shows divergence, then this is a signal for a possible downward movement, which we can use to open a sell position.

Classic Bear Divergence

Dotted lines help you determine if the second maximum is above or below the first.

Classic Bullish Divergence:

In order to identify the usual bullish divergence on Forex, we must look at the lows, or bottoms, of the price chart and indicator. A common bullish divergence occurs when the price chart draws a lower low and the indicator chart draws a higher low. Like the foregoing, it is not necessary at all for this to be a series of lower lows on the price chart; just see one lower minimum compared to the previous one. If the indicator shows divergence, then this is a signal for a possible upward movement, which we can use to open a buy position.

Classic bull divergence

Dotted lines help you determine if the second low is above or below the first.

As you can see from these examples showing divergence, in most cases, you will see a line connecting the first maximum (or minimum) with the second maximum (or minimum), both on the price chart and on the indicator. This is the best way to clearly detect divergence. In the future, you will see the divergence visually, but for starters, while you are just starting to master this signal, the connecting lines will help you with this. I have been using divergence as a signal to enter the market for many years, but even now I still draw these auxiliary lines on my charts.

Hidden Divergence

Hidden divergence is divergence, which is a signal of the continuation of the trend and it is much more difficult to see it. Very few traders know about its existence. Like ordinary divergence, hidden divergence can be a signal to open either a long or short position.

  • Hidden bearish divergence indicates that the price chart continues to go down.
  • Hidden bullish divergence indicates that the price chart continues to go up.

Hidden bearish divergence:

In order to reveal the hidden bearish divergence, we must look at the highs, or peaks, of the price chart and indicator. Hidden bearish divergence occurs when the price chart (market), moving down, draws lower highs. The indicator in this case, displaying divergence, draws a higher maximum.

Hidden Bear Divergence

Dotted lines help you determine if the second maximum is above or below the first.

Hidden Bullish Divergence:

In order to identify hidden bullish divergence, we must look at the lows, or bottoms, price charts and indicator charts. Hidden bullish divergence occurs when the price chart (market), moving up, draws higher lows. The indicator in this case, displaying divergence, draws a lower low. 

 

Hidden Bullish Divergence

Dotted lines help you determine if the second low is above or below the first.

Hidden divergence is sometimes compared with a slingshot. The meaning is that the indicator acts as a slingshot - after a small correction, the market will catapult in the same direction in which it is already moving. The indicator displays a small rollback, giving you a good signal to enter the market.

Extended divergence

Extended divergence is similar to ordinary divergence, however, in this case, the price chart draws a figure very similar to a double top or double bottom. Along with the fact that the second peak (or bottom) on the price chart is at the same level as the first, the indicator draws a second maximum (or minimum) at a different level, which differs significantly from the first. This extended interpretation of market behavior indicates that the market continues to move in the same direction.

Quite often, if the market makes similar ups and downs, it is hoped that some consolidation will occur. Expanded divergence may indicate that the market still has sufficient potential to continue its movement and that consolidation has not yet occurred.

Extended divergence is one of the varieties of ordinary counter-trend divergence. You will see it every time at the bottom of a powerful market movement, at a time when the market begins to think about stopping its movement. Instead of changing the direction to the opposite and instead of forming a consolidation figure, the market will continue to move in the same direction.

  • The extended bearish divergence indicates that the price chart continues to go down - time to sell.
  • Expanded bullish divergence indicates that the price chart continues to go up - time to buy.

Extended Bear Divergence:

In order to identify the extended bearish divergence, we must look at the highs, or peaks, of the price chart and indicator. Expanded bearish divergence is usually detected at the top of a large movement. The market forms a kind of double top, but it is important to note the fact that the double top does not have to be classical: the second maximum may be slightly higher or lower than the first. Despite the fact that the highs on the price chart are approximately at the same level, the indicator will show a significantly lower second high. The indicator DOES NOT KNOW a double top, similar to the market movement chart. The relationship between the price chart and the indicator will seem rather extraordinary ... expanded.

Extended Bear Divergence

Dotted lines help you determine if the second maximum is above or below the first.

Highs on the price chart are located at approximately the same level, resembling a double top. The indicator shows a significantly lower second maximum.

You can approach this situation on the other hand: without thinking about extended divergence, you can see that the price chart draws a double top (or double bottom), while the indicator does not try to form a double top (or double bottom) similar to the market. It looks like the indicator just stopped trying to copy the price movement.

Expanded Bullish Divergence:

In order to identify extended bullish divergence, we must look at the lows, or bottoms, of the price chart and indicator. Expanded bullish divergence is usually detected on the bottoms of a large movement. The market forms a kind of double bottom, but it is important to note the fact that the double bottom does not have to be classic: the second minimum may be slightly higher or lower than the first. Despite the fact that the lows on the price chart are approximately at the same level, the indicator will show a significantly higher second minimum. The indicator DOES NOT DRAW a double bottom similar to the market movement chart. The relationship between the price chart and the indicator will seem rather extraordinary ... expanded.

Expanded Bullish Divergence

Dotted lines help you determine if the second low is above or below the first.

Lows on the price chart are located at approximately the same level, resembling a double bottom. The indicator shows a significantly higher second minimum.


Conclusion

Forex divergence is a constant phenomenon and is one of the most powerful elements of technical analysis. However, seeing divergence on a live chart is not easy. Experience can help you with this.

Naturally, you should not rely on divergence alone when opening a position on Forex. Other indicators, graphical patterns, support / resistance levels and Price Action signals should be taken into account.

The next time you use oscillators, do not forget about divergence, this is really important.

Watch the video: Dale Pinkert on forex, Fibonacci, RSI, VIX, stop losses & more. trading rsi indicator divergence (November 2019).

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