Divergence trading system

List of Partners vendors. Because trends are composed of a series of price swings, momentum plays a key role is assessing trend strength.

As such, it is important to know when a trend is slowing down. Less momentum does not always lead to a reversal, but it does signal something is changing, and the trend may consolidate or reverse. Price momentum refers to the direction and magnitude of price. Comparing price swings helps traders gain insight into price momentum. Here, we'll take a look at how to evaluate price momentum and show you what divergence in momentum can tell you about the direction of a trend.

Divergence Cheat Sheet (With Trade Examples)

The magnitude of price momentum is measured by the length of short-term price swings. The beginning and end of each swing is established by structural price pivots, which form swing highs and lows. Strong momentum is exhibited by a steep slope and a long price swing. Weak momentum is seen with a shallow slope and short price swing. For example, the length of the upswings in an uptrend can be measured. Longer upswings suggest the uptrend is showing increased momentum, or getting stronger. Shorter upswings signify weakening momentum and trend strength.

Equal-length upswings mean the momentum remains the same. Price swings are not always easy to evaluate with the naked eye because the price can be choppy. Momentum indicators are commonly used to smooth out the price action and give a clearer picture. They allow the trader to compare the indicator swings to price swings, rather than having to compare price to price. Common momentum indicators for measuring price movements include the relative strength index RSI , stochastics, and rate of change ROC. The default setting for RSI is RSI has fixed boundaries with values ranging from 0 to For each upswing in price, there is a similar upswing in RSI.

When price swings down, RSI also swings down. Figure 2: Indicator swings generally follow the direction of price swings A. Trendlines can be drawn on swing highs B and lows C to compare the momentum between price and the indicator. The study of momentum simply checks whether price and the indicator agree or disagree. Figure 3: Compare price and indicator to make better trading decisions.

Disagreement between the indicator and price is called divergence, and it can have significant implications for trade management. For this article, the discussion is limited to the basic forms of divergence.

It is important to note there must be price swings of sufficient strength to make momentum analysis valid. Therefore, momentum is useful in active trends, but it is not useful in range conditions in which price swings are limited and variable, as shown in Figure 4. Figure 4: In range conditions, the indicator does not add to what we see from price alone. Variable pivot highs and lows show range. Divergence in an uptrend occurs when price makes a higher high but the indicator does not. In a downtrend, divergence occurs when price makes a lower low, but the indicator does not.

When divergence is spotted, there is a higher probability of a price retracement. What is relative strength index RSI? Mistakes while trading divergence. The meaning of the word divergence is to move apart. In forex what divergence means is, when the price and the oscillator indicator does not agree with each other or when they move apart, then it is said to be a divergence. A divergence is found by comparing the price action with the oscillator indicator.

Consider the price action is moving down and creating continuous Lower Lows. So, as the indicator is developed to follow the price action, the indicator should also create Lower Low. But in the case of divergence, the indicator does not agree with the price and creates Higher Low. What the indicator is trying to tell us is, that something in the market is not right and hence we can expect a reversal. For example.

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So, this tells us that indicator is not agreeing with the price action, and hence, you can see the price reversed from there onwards. The divergence is usually identified by using an oscillator indicator. The oscillator indicator usually consists of two levels, overbought and oversold, respectively. The upper level is of and indicates overbought region, and the lower level is of and indicates oversold conditions.

The most commonly used oscillators for spotting divergence are. MACD moving average convergence divergence. As per our experience with divergence, the divergence works best on RSI. So, we will first try to understand what is RSI and how does it works, and then we will learn about RSI divergence throughout this blogpost. The Relative Strength Index is a momentum oscillator Indicator which calculates the strength of the price changes happening in the market to show overbought and oversold conditions. The RSI is shown as the line between two extreme levels.

The overbought and oversold levels can be set anywhere between Understanding the indicator correctly can help you understand the concept of the divergence correctly. So, let us try to understand the RSI correctly before we move on further. Below is the example of the RSI with levels 30 and In the example above, we have the RSI installed in the trading view chart. The two blue lines in the indicator window represent the overbought and oversold levels. We have set the overbought level to 70 and oversold level to The line which is following the price action and moving exactly like the price but between those two extreme levels is the RSI.

When the RSI line approaches the 70 levels on the indicator, it shows short term overbought levels. When the RSI line approaches the 30 levels on the indicator, it shows short term oversold region. In the example above, you can see, as the RSI line approached the oversold level, buyers came into the market and pushed the price higher. When the RSI line approached the overbought level, sellers came into the market and pushed the market lower. In more simpler terms the RSI gives us the short term opportunity to buy lower and sell higher.

Now, that you have understood the working and use of RSI let us move on further and see the different types of divergence. These are the most used divergence and are very easy to spot.

Regular divergence is found at the top and bottom of the trends, and they mostly give a reversal signal. Let us try to understand each one with examples. Formation - When the market is in a downtrend and creates continuos lower lows and lower highs, a bullish divergence is formed.

As the price action is creating the lower lows, the indicator should also do the same, but the indicator creates higher lows instead, and this is called a bullish divergence. As you can see in the example above, on the USD-JPY 4-hour chart, the price was continuously moving down and creating lower lows, but when we compare it with the indicator, the indicator was making higher lows.

This is called a bullish divergence. And you can see the price reversed after creating a bullish divergence. The stochastic oscillator is a very useful tool for technical analysis. A detailed guide to stochastic trading is in the article devoted to the Stochastic Oscillator. Unlike the oscillators covered above, the Awesome Oscillator divergence indicator looks like a histogram, not like a curved line. Next, the sell trade is exited with a profit, and a purchase is entered after the regular bullish divergence appears. The entry levels for both a short and a long are marked with a blue horizontal line.

At the entry points, the Awesome Oscillator breaks through the zero line. I marked the entries with green circles. An important feature of the AO is that the signal is sent when the indicator crosses the zero level. When the AO breaks through the zero line, the local or the global trend should reverse. So, when the price extremes are separated by such crossing cannot be with the same signal pattern.

To avoid such an error, you should check the same divergence on a longer timeframe. If the signal is not broken there, you can use it in trading.

I have already mentioned that the Bollinger bands are well combined with the divergence signal. Bollinger Bands is a trend indicator, so we need an oscillator to define a divergence. I will take the MACD as an example. If you are not yet familiar with the Bollinger Bands indicator, I strongly advise you to read the article Bollinger Bands Indicator. I described the double Bollinger band trading strategy.

In short, it suggests attaching two Bollinger Bands indicators to the price chart. One indicator is with coefficient 1; another is with coefficient 2. Finally, the chart is divided into three zones, where the central green band is a neutral area, and the red bands upside and downside are the buyer and the seller zones. The common strategy of double Bollinger Band divergence suggests that if a reversal followed the upward trend and the price entered the bottom red band, there should start a bear trend.

In the opposite situation, when the price enters the top red band, there should start a bullish trend. It is clear from the above chart that the strategy also delivers false signals.

So, divergences here are a good filter. However, the MACD paints lower highs. This is an example of regular divergence. If you discover such as signal moving average convergence divergence macd, the trend must soon reverse. We enter a trend earlier when the candlestick closes in the green zone and the MACD moving averages while the histogram goes into the negative area. We put a stop loss a little higher than the most recent local high. We should exit the trade when there is an opposite divergence signal of the trend reversal. It is clear from the chart that the signal is delivered in January.