How to Trade Indicator Divergence

Definition and Different Types

At the beginning of their trading career, newbies eagerly surf the web, get engrossed in several books and religiously follow traders’ blogs in order to find the best trading tool, the holy grail of trading.

Reality check: it doesn’t exist.

There are a wide range of trading tools out there, but every strategy or indicator has advantages and drawbacks. Some are suited well to specific market conditions while some fare better in others. The more traders know these tools, the more profitable they are likely to be. You have to know your instruments in order to exploit the market.

Indicator Divergence is one of the easiest trading tactics, but one to be used with caution in order to minimise false signals.

Divergence means ‘going in different directions’ and this is exactly what traders are looking for to apply this strategy. Specifically, they want to see divergence between price and indicator. The majority of traders look at oscillators such as RSI, Stochastics, CCI and MACD in order to identify possible divergences and exploit these differences.

There are two kinds of Indicator Divergence:

1. Negative Divergence

Negative Divergence occurs when price makes new highs, while the indicator shows lower tops, as shown in the chart below.

Negative Divergence

(DAX Future, Daily)

2. Positive Divergence

Positive Divergence occurs when price hits new lows, while the indicator shows higher bottoms, as shown in the chart below.

Positive Divergence

(USD/JPY, 4h chart)

Trading Applications

Negative and Positive Divergences may provide reversal signals, because traders should go short in the first example, and long in the second, exploiting the divergence between price and indicators.

However, they can also produce false signals, so the results of trading using Indicator Divergence can be varied. To reduce false signals, traders need to know the positives and negatives of the Indicator Divergence tactic, as well as understanding the market environments in which this tool will work.

Below are a list of points worth bearing in mind:

  • Divergence is more reliable when it occurs in extreme conditions, for example overbought or oversold markets. If you use the RSI indicator, look for divergence above 80 or below 20, as shown in the chart below.

Divergence

  • Consider the market environment: if you use oscillators such as Stochastics, RSI, MACD and CCI, remember that their signals are more reliable in trading range conditions than in trending markets.
  • Consider the timeframe: the higher the timeframe, the more reliable the signal. For example, a divergence on a daily chart is more reliable than one on a 5 minute chart.
  • Consider your entry points: the Indicator Divergence strategy doesn’t provide signals regarding timing, so you’re on your own when it comes to finding a good entry level. Here are two types of entry that might work:

1) Entry in volée: Entry without confirmation can be a dangerous option, but it can work well with reference to risk ratios. Therefore, enter in vole when markets are close to an important price level and the trend can be considered mature. Once these conditions are confirmed, enter as soon as divergence occurs, and use a very strict stop loss.

Entry

2. Entry with confirmation: Enter the market after a reversal signal such as a breaking of a trend line, reversal bar chart pattern or Japanese candlestick’s reversal pattern. If you see a reversal signal in conjunction with Indicator Divergence, follow the signal.

Entry2

In conclusion, remember you’re trading the price and not just the indicator. Indicator Divergence is a powerful trading tool if you use it considering the features of the indicator and the market situation, as shown above.

Take a look at some great strategies using MACD & RSI below 

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