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How to Trade a Divergence - A Step-by-Step Divergence Trading Guide

Sebencapital

Published
11/10/23
Exploring the Top Day Trading Strategies

Divergences stand out as one of my preferred trading concepts due to their ability to yield dependable and high-quality trading signals when integrated with other trading tools and principles.

While it's true that indicators, like price action, exhibit some lag, this lagging aspect becomes an asset when it comes to divergences. It assists us in pinpointing superior and more dependable trade entry points as we explore further. Divergences can be valuable to traders seeking reversals and those following trends, aiding them in effectively timing their exits.

In my personal trading strategy, divergences play a significant role within one of my setups, particularly when combined with additional signals. It's worth noting that trading divergences in isolation aren't advisable, but they serve as an excellent foundation for your trading endeavors.

What Is A Divergence?

Let's dive right into the most straightforward question and delve into the essence of divergence and what it conveys about price movement. You might be surprised at how often people misunderstand this concept.

A divergence takes shape on your chart when the price is higher while the indicator you rely on registers a lower high. When your chosen indicator and price action do not align, it signals that there's something noteworthy occurring on your charts, which may not be immediately apparent by simply glancing at the price data.

A divergence arises when your indicator doesn't "concur" with the price action. While this is a fundamental concept, we'll venture into more advanced divergence ideas and explore how to trade them effectively. Nevertheless, establishing a strong foundation by understanding this basic concept is paramount.

RSI DIVERGENCE

Bearish and bullish divergences are crucial concepts in trading, emphasizing when the price and the indicator display conflicting signals, ultimately hinting at a potential reversal.

An Rsi Divergence

1. Revisiting the RSI

Divergences are a versatile tool applicable to various indicators, but my top choice is the RSI (Relative Strength Index). The RSI assesses the average gain and average loss within a defined timeframe. For instance, setting your RSI to 14 calculates the relative strength of bullish and bearish movements over the previous 14 candles.

When the RSI value is low, it implies that the past 14 candles witnessed more and more potent bearish movements than bullish ones. Conversely, a high RSI reading suggests that the preceding 14 candles saw more and stronger bullish movements than bearish ones.

The RSI's ability to gauge the balance between bullish and bearish forces within a specified period makes it a valuable tool for traders, and it's particularly effective for identifying divergences that can signal potential trend reversals.

2. When does an RSI divergence form?

Understanding your indicator's high and low points is important in deciphering divergences. I often urge traders to look beyond the zigzag lines on their indicators and grasp the essence of what they truly signify.

During trending market conditions, the RSI can be a precious tool for assessing the strength of those trends by comparing individual trend waves. Here are three key scenarios, each illustrated in the screenshot below:

  • Higher Highs in RSI During Healthy Bullish Trends: Typically, the RSI will form higher highs in robust and healthy bullish trends. This indicates that the most recent trend wave witnessed more bullish movements.
  • Equal Highs in RSI during Uptrends: When the RSI maintains similar highs during an uptrend, the trend's momentum remains unchanged. This doesn't qualify as a divergence because it simply signifies that the uptrend's strength is consistent and stable. Higher RSI highs, in this case, do not indicate a reversal or weakness but rather the continuity of the trend.
  • Lower Highs in RSI during Bullish Trends with Price Making Higher Highs: If you observe that the price is achieving higher highs during a bullish trend, but the RSI is forming lower highs, this implies that the recent bullish movements are not as robust as the preceding price action. This divergence signals a loss of momentum in the trend and often foreshadows a potential end to the uptrend, opening the door for a downtrend.

Recognizing these three scenarios and their implications can empower traders to make more informed decisions when interpreting RSI movements and identifying potential trend reversals.

RSI during Bullish Trends

3. Conventional technical analysis is flawed.

Classic technical analysis conventionally defines a trend as the price forming higher highs. However, as is often the case, conventional wisdom tends to oversimplify things. Relying solely on high and low points for price analysis can cause traders to overlook vital hints and fail to grasp the intricacies of market dynamics.

A closer examination of individual candle patterns and momentum can reveal a different story, even when a trend appears "healthy" on the surface, characterized by higher and lows. A trend can lose momentum simultaneously, which isn't immediately apparent when assessing high and low points.

Identifying a divergence on your momentum indicator signals that the trend dynamics are shifting. While the trend may still appear valid, this divergence indicates that a potential end to the trend might be approaching. It underscores the importance of delving deeper into market dynamics beyond the surface-level analysis of highs and lows.

How To Trade A Divergence – The Optimal Entry

Not every instance of a divergence leads to a significant trend reversal; often, the price enters a period of sideways consolidation after a divergence is observed. It's important to remember that a divergence primarily signals a decrease in momentum but doesn't necessarily indicate a complete shift in the prevailing trend.

To prevent entering trades that go nowhere, it is strongly recommended to incorporate additional criteria and confirmation tools into your trading toolkit. Relying solely on a divergence as your sole indicator may not yield favorable results. Like any other trading strategy, it's crucial to incorporate multiple factors that align with your divergence signals to strengthen your overall trading strategy.

For instance, consider the example below, where the price exhibited two divergences, but a significant price decline did not follow. These divergences merely indicated short-term consolidation in the market.

HOW TO TRADE A DIVERGENCE

Tip: Location

The location holds universal significance in trading, regardless of your chosen trading system. Incorporating the concept of location into your strategy can substantially improve the quality of your signals and overall trade execution. Instead of relying on divergence signals to initiate trades, waiting for the price to reach a previous support or resistance zone is advisable. Then, you can use divergences and trend shifts as timing indicators for your entries.

Consider the screenshot below a valuable example: On the left side, there's an uptrend with two divergences. However, the first failed, while the second resulted in a significant win. What made the difference? When we examine the higher time frame on the right, we can see that the first divergence occurred in a less significant price area, whereas the second one formed at a crucial resistance level (highlighted by the yellow line and arrow). As a trader, your initial step should be identifying your support and resistance zones and patiently waiting for the price to approach them. This approach can have a substantial effect on your trading performance.

RSI DIVERGENCE

Divergences represent a potent trading concept. Traders who grasp how to effectively trade divergences within the appropriate market conditions and with the right signals can establish a strong and efficient approach to analyzing price movements.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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