In the previous article, we looked at the concept of divergence and the original concept as outlined by Charles Dow in his Dow Theory. We learned that the concept of divergence can be applied to any market and can be used as a relative comparison between two securities, such as the Dow Jones Industrials and the Dow Jones Transportation indexes.
In this article, we explain how divergences are formed, in the context of the forex markets and relative to the indicators and outline the different types of divergences that are formed.
The concept of divergence in the forex markets
In the forex markets, or for that matter, even futures or stocks, divergence is often related to the price and the oscillator that is tracking the prices. Divergences can be spotted by use of oscillators only and among the many different oscillators, the MACD, Stochastics, RSI, Awesome Oscillator, CCI, Williams %R are some of the more commonly used oscillators.
An oscillator is used to track the overbought and oversold prices. Because most of the oscillators are based on price and the relative momentum or volume, oscillators are the best choice for understanding momentum in prices which signal how strong the prevailing trend is.
When prices reverse or retrace, the oscillator tends to follow the same pattern. Therefore, when prices are making higher highs or higher lows, the oscillator tends to mimic the same pattern. Conversely, when prices are making lower highs and lower lows, the oscillators tend to print the corresponding lower highs and lower lows. This is what we already knew as convergence.
When price makes a high or a low and the oscillator fails to confirm the same, it is known as divergence. By spotting these divergences, traders are usually signaled to a potential change in the direction of prices.
How are divergences formed?
Divergences are formed when there is a mismatch between the price action and the momentum, measured by the oscillator relative to price. Quite often you will notice that divergences tend to occur near support and resistance levels.
Therefore, divergence trading can be used not only to time the entry into a trade within a trend, but it can also help you to understand support and resistance levels. While divergences are broadly classified into 4 types, the underlying theme among all the four types of divergence is that it shows price exhaustion when the oscillator fails to confirm the new highs or the lows.
Divergences take place all the time and across all time frames. However, the best results come when divergence is spotted on higher time frames such as 4-hour sessions or higher.
One of the most common mistakes often made with divergence trading is that traders expect the price to behave in a certain way when a divergence is spotted. This is wrong! Just because a divergence is formed, doesn’t mean that price will reverse. In the charts that are outlined in this article, you will find a few divergence setups where price moved in the opposite direction, contrary to what the divergence was telling you.
It is, therefore, important to understand that traders should look at other confirmation tools (which will be covered in a later article) before trading the divergence setups.
Types of divergences
There are 4 types of divergence, which are broadly classified into two categories:
- Regular or Classic Divergence
- Hidden Divergence
With each of these two categories, you have a bullish or a bearish divergence. Therefore, the four types of divergences are summarized as:
- Regular Bullish Divergence
- Regular Bearish Divergence
- Hidden Bullish Divergence
- Hidden Bearish Divergence
The chart below gives a quick overview on the above 4-types of divergences.
Divergence Table (Price and Oscillator)
|High -> Higher High||High -> Lower High||Regular Bearish Divergence|
|Low -> Lower Low||Low -> Higher Low||Regular Bullish Divergence|
|High -> Lower High||High -> Higher High||Hidden Bearish Divergence|
|Low -> Higher Low||Low -> Lower Low||Hidden Bullish Divergence|
Examples of Bullish and Bearish Divergence
The following two charts show examples of the above four types of divergences that occur on the price chart. In the below examples, we make use of the Stochastics oscillator. But feel free to experiment with other oscillators mentioned earlier in this article.
Spotting divergence takes time and does not expect results overnight. The best way to get started with spotting divergence is to use one of the many custom divergence indicators that are available for MT4. These automated indicators spot the divergence for you which can act as a good starting point to understand the highs and lows. In terms of which oscillator to use, the RSI makes for an ideal oscillator to train your eye to spot the divergences. Simply switch the price chart to a line chart and then add the RSI, which makes for an easier way to train your eye.