Best Ways to Trade Divergences

Have you ever been caught on the wrong side of the trade, perhaps buying a move at the top or selling at the bottom, and witnessed the market quickly reverse on you? This is an event that virtually every trader has gone through at some point. But what if there were a way for you to recognize the signs of a reversal developing before it occurs?

These are the benefits of trading divergences. When you highly learn to gauge the difference or divergence between price action and momentum indicators, you will have an advantage in trading that will allow you to execute trades even before price moves or at least distinguish to exit trades much earlier to avoid losing trades or holding onto losers longer than intended.

In this article, we will discuss the best approach to trading divergences, including how to recognize them, the necessary tools, entry and exit strategies, and common pitfalls to avoid.

What Is Divergence In Trading?

Divergence occurs when the price of an asset is moving in one direction, while an indicator provides conflicting information and shows a contradictory observation. For example:

• Price is making new highs, while the indicator is actually making a lower high.

• Price is making a new low, whereas the indicator will be making a higher low.

The contradiction will indicate momentum behind that move is weakening, which could be an early sign that the current trend will reverse, or stall temporarily; it could also be the start of a continuation trend, depending on the type of divergence.

Types of Divergence Every Trader Should Understand

Regular Divergence

• Bullish regular divergence indicator: Price is making lower lows, but the indicator is making higher lows. This provides a strong indication of an upward trend.- Bearish regular divergence: When the price is making new higher highs, while the indicator continues to show lower highs, there is a chance that upward momentum could reverse course. Regular divergence is perfect for finding reversals in the market.

- Hidden Divergence

- Bullish hidden divergence: The price is showing higher lows, and the indicator is showing lower lows. This indicates upward momentum will continue.

- Bearish hidden divergence: The price is showing lower highs while the indicator is showing higher lows, indicating downward momentum will continue.

- Hidden Divergence is best to confirm that a trend is still intact.

COMMON INDICATORS THAT ARE USED FOR DIVERGENCE.

To utilize divergence, you want to have the right tools. The most common indicators used are:

-RSI (Relative Strength Index): A momentum oscillator that makes it generally easy to see divergences.

-MACD (Moving Average Convergence Divergence): A measure of the relationship of two moving averages. This is a valuable indicator for both regular and hidden divergence.

-Stochastic Oscillator: Works well for short timeframes and quick divergences.

-CCI (Commodity Channel Index): A different measure of momentum and change in momentum.

Your choice should be the indicator that is best for yourself. Find one or two that work well for you, practice, and you will be able to read it profitably.

BEST WAYS TO TRADE DIVERGENCE

1. Using Divergence with Support and Resistance.

One of the better trades is when both divergence is detected, in value, near significant support and resistance. For instance, when the price is at the resistance level and creates a new high, if the RSI is making lower highs, we have a strong indication that the price is likely going to hold this level and reverse.

2. Wait on Candlestick Confirmation

Divergence itself is not a signal for entry. When you are waiting for candlestick formations like engulfing bars, pin bars, or doji, confirm the reversal is more robust (by limiting false entries), giving you additional confidence in your trading.

3. Use Multi-Timeframe Analysis

Divergences observed on higher timeframes are stronger signals. For example, a bearish divergence observed on a daily timeframe is more weighty than the same signal on a 5-minute timeframe. You can then zone in on a finer timeframe and time your entry.

4. Trade with the Trend Using Hidden Divergence

Hidden divergences are best used as a continuation tool. If the price is making a higher low while the RSI is making a lower low when trading in an uptrend, the buyers are still in control. Trading in the direction of the trend in that situation will generally provide recommendations for trading opportunities.

5. Place Logical Stop-Loss and Take-Profit Objectives

Stop-losses should be placed slightly beyond the next level that invalidates the divergence form - for example, in a bearish divergence trade, a stop-loss above the recent high is logical. Take-profits can be based on previous swings or Fibonacci retracements.

6. Use Divergences in Combination with Other Tools

Confluence strengthens results. When divergences coincide with trendlines, moving averages, or Fibonacci zones, the chances of success rise dramatically.

A Sample Divergence Trade

Let’s say the EUR/USD is in an uptrend first. The price is making a higher high at resistance, and the RSI is printing a lower high. This is a bearish “regular” divergence. You are waiting for confirmation, and you see a bearish engulfing candle at that resistance zone.

• Entry: You’ll sell after the candle is closed.

• Stop Loss: You will put it just above the recent high.

• Target: Prior swing low or Fibonacci Retracement.

This would be a trade involving divergence as well as support/resistance and candlestick confirmation – you are stacking the odds in your favor.

Common Mistakes Trading Divergences

It is essential to mention that even a well-developed crait setup using divergence can create simple mistakes that may be avoided:

• Forcing divergence: This is seeing divergence everywhere, so pay attention to the confirmation.

• Ignoring context: Do not trade against strong fundamentals and/or against (dominant) trends.

• Jumping the gun: It is essential to wait for price action and not trade the first possible divergence signal—wait for a candle to close!

• Over-emphasizing indicators: Divergence is there to support the analysis rather than replace the use of price analysis.

If these mistakes are avoided, your divergence strategy will be more effective in the future.

Tricks to Assimilate Divergence Trading More Easily

• Be patient: Divergences take time to develop.

• Keep your charts right: Too many indicators can create confusion.

• Make sure to journal trades: Watch how you trade the divergences and practice until you know how they work best.

• Quality over quantity: Rather than chase every divergence trade signal, ensure a few good divergence trades.

Summary

Divergence trading is one of the best methods to know and understand when price and momentum are out of sync. By studying and learning the differentiation between regular and hidden divergence, using tools like the RSI or MACD, and incorporating divergence to support/resistance levels or candlestick confirmation, I am confident that you will gain a better understanding of timing trades—you will have a higher level of confidence.

Although the most effective way to trade divergences is not being dependent, it is about incorporating it into your overall strategy, which should include risk management and patience. When it is understood correctly, it will help avoid bad entries, provide an early opportunity to be in reversal trades sooner, and work with higher confidence with trend trades.