What are Divergences and how to use them to increase Forex profits

Divergences occur when the price of a currency pair and an oscillator-type indicator move in opposing directions. In technical analysis, you can make decisions by identifying situations where the divergence (for example the price of a currency pair moves in a contrarian direction from another indicator as for example the Moving Average Convergence/Divergence – MACD).

There will be a divergence when:

a) The price of a currency pair makes a new low, while the indicator starts moving up, or

b) A currency pair reaches a new high, but the indicator doesn’t match the move.

MACD divergence is one of my favorite indicators, so here we have an example below:

Following a strong trend in either direction, traders should look for a divergence on the MACD histogram. For example, in a bullish market, when the MACD bar is unable to reach a new high and is showing lower highs in respect to the previous levels. When this happens, the price of the currency pair might still be rising but there is a possibility that sooner or later the trend will reverse.

Tip: Sometimes we are looking for new highs or lows, but in fact double tops and double bottoms mixed with divergences can give way to a very strong entry or exit signal, as shown on the chart above.

As soon as a currency pair has made a new high and then retracts, the high of that retraction must be identified. If prices reach the same high while their MACD (or RSI or Stochastics) doesn’t match the move, one should be considering selling the currency pair at a level near that high, with a stop-loss a little above the initial high price. The inverse would be true for a long position.

Divergences are considered as a very effective tool to employ in trading Forex markets. A divergence will show up when the prices are having highs and lows in a definite direction inside the market, while an indicator of the oscillator type shows an opposed trend in regard to what is being observed in prices. In simpler words, divergences arise when you compare the movement of the prices with that of a technical indicator.

Divergences are considered important signals and it is recommended to use them along with other confirming indicators.188

In the Forex market, technical indicators of the oscillator kind allow the trader to observe divergences between prices and indicator, which generally indicate with anticipation possible changes in market trends, or simply show what can be the next market continuation. Some of the indicators that allow traders to spot divergences are MACD, RSI and Stochastics.

There are two kinds of Divergences:
1. Classical or regular divergences
2. Hidden divergences

Classical divergences will generally indicate with anticipation a possible radical change of the market trend.

Hidden divergences allow traders to see with anticipation which way will the market continue after a period of consolidation.

How to use divergences?

Classical divergences are used as explained below:

When the prices or a currency pair are showing minimal lows, while the indicator is showing higher lows or is simply starting to rise, then this will indicate a possible change in the market from a bearish to a bullish trend. The same can occur on the opposite side, if they show very high maximum prices or new highs and the indicator is showing lower highs, then the market will possibly change from a bullish to a bearish trend.

Bullish classical divergence is formed in a bearish trend: Price makes a lower low, indicator makes a higher low.

Bearish classical divergence is formed in a bullish trend: Price makes a higher high, while indicator makes a lower high.

Hidden divergences will be used as follows:

When the prices or a currency pair is presenting higher lows while the indicator shows lower lows or is simply starting to fall, then we can expect a possible continuation of the market to a bullish trend. The same occurs when we have higher highs or new highs, and the indicator shows lower lows, this will indicate a continuation to a bearish trend.

Bullish hidden divergence is formed in a bullish trend and confirms it: prices will show a higher low while the indicator presents a lower low.

Bearish hidden divergence is formed in a bearish trend and confirms it: prices will show a lower high while the indicator presents a higher high.

To obtain higher profits using divergences you will need to follow the rules to trade them so your potential losses can be reduced:

• For a divergence to be confirmed, you always have to look for the following signals of the market prices:

1. Higher highs or new highs

2. Lower lows
3. Double Top

4. Double Bottom

If you can’t find this in the first place, it is better not to look for an indicator to buy neither to try to see which divergence it is.

• When you are trading, it is recommended to draw a line between the previous higher price and the new high. Do the same with the lower previous low down to the new lows so you can perform your analysis in a faster and clearer way.

• If a divergence occurs, and the market has moved or reversed at a certain point, you can’t do anything nor try to do something, because you could fail. If this happens and you realize that there was a divergence and you didn’t see it on time, wait for the market to show again a new divergence before acting.

• Divergences on longer time-frames are more dependable. You will get less false signals. On long periods you will obtain fewer trades but their profit potential will be much higher. Divergences on shorter time-frames will be more frequent but are less credible. I would recommend to only use divergences from 1 hour and up.

• It is important to always analyze, outline and observe carefully the histograms in order to be able to detect the signals on time and never make a move if you are not absolutely sure.

• Remember that no investment is free from risks and that an indicator will help you with your trades more effectively if it is used along with other tools.