Divergences and Why They Work in Trading

Divergences and Why They Work in Trading

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Divergences between different technical indicators, and between indicators and price, is an interesting concept in technical analysis that appears to work remarkably well. In this article, we will take a closer look at what they are, why they work, and how you can use them to profit consistently from any financial market – forex, stocks, or cryptocurrencies.

What Is a Divergence?

A divergence in a chart is something that occurs when two or more indicators provide conflicting signals by moving in opposite directions. Alternatively, it could also be considered a divergence if for example the stock price of two companies in the same industry moves in different directions. If you spot such a situation, it could be worthwhile taking a closer look at what is really going on.

The four red lines in the chart below represents divergences between the Relative Strength Indicator (RSI) and the price. Notice how the price continues to make new highs, while the RSI at the same time fails to make another high. As a result, we got a divergence between the trendlines on the price and the RSI – an amazingly accurate predictor of a change in market direction that you should pay attention to! 

Divergences

Why Divergences Work

If we stick with the RSI vs. price divergence shown above as our example, let’s look at why it works so well for predicting reversals in the market.  

In short, the divergence below shows us that the strength of the prevailing price movement is decreasing. In both cases shown above, we can see that the vertical distance between the tops in the market has decreased, confirmed by the downward trendline on the RSI. In other words, the bulls are running out of steam and are about to get exhausted – a clear sign that sellers are about to take the lead in the market.

How to Use Divergences in Trading?

Now, let’s finally answer the most important question of them all; how can you spot and use divergences in your own trading?

To spot a divergence, you need a chart that shows at least two different variables. To start with, I suggest going with the same set-up as our example above; price and the RSI indicator. Quickly scan the RSI and look for situations where it reversed from an uptrend to a downtrend, or vice versa.

Now find the corresponding area in the price chart. Is it showing a high in the market followed by a slightly higher high? If yes, you have found an interesting situation. If you study a few of these set-ups, you will find that more often than not, the price starts to move down shortly after the price and RSI divergence.

Over time, you will feel comfortable enough to look for these set-ups in real time and take advantage of them in your live trading. To get more action, one trick is to move down to the lower timeframes, perhaps the 1 hour or even 15 min timeframe, and scan a few markets to find the best situations.

If you prefer a more relaxed experience, move back to your usual timeframe like the 4 hour or the daily, and scan more markets to ensure you find suitable set-ups. With experience, spotting the best divergence set-ups becomes somewhat of an art and you will intuitively be able to tell a good one from a bad one.

Good luck!

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