Divergence in forex trading happens when the price of the traded currency pair is moving in the opposite direction of a technical indicator, usually an oscillator.
In trading, divergence is seen as a warning sign that the current price trend is waning and about to reverse. Divergence happens when prices lack clear directional trends, alerting traders that current prices are about to reverse.
Divergence can be bullish or bearish. Bullish divergence indicates that the price is about to move higher. While the bearish divergence indicates lower prices.
Learn more about Bullish and Bearish market trends.
Forex Divergence Explained
Divergence is a powerful signal in technical analysis that points out positive or negative price moves ahead. A positive divergence occurs when the price makes a new low, while the indicator moves higher. On the other hand, negative divergence is when the price form new highs while the indicator makes a lower high.
For example, when the price of a currency pair is moving higher and forming new highs and the MACD is making lower highs, it is a warning sign that the price trend is losing momentum and most probably will reverse.
Usually, divergence is used to asses the price momentum and the odds for price reversals.
Divergence Technical Indicators
Oscillators are the best and most common indicators used to detect price divergence in forex trading. Popular oscillators used for identifying divergence are:
Moving Average Convergence and Divergence (MACD)
The MACD is a trend-following momentum indicator that assesses market forces and indicates changes in momentum, direction and strength of a price trend. MACD is calculated by subtracting the long-term exponential moving average (EMA) from the short-term EMA. The indicator is bullish when the MACD line is heading up, and bearish when it falls lower below the zero level.
Stochastic is another popular momentum indicator that is created to show overbought and oversold zones. It is commonly used to identify possible profit-taking levels due to its ability to pinpoint where the price is expected to reverse. Also, it can measure price momentum by comparing trading range and closing price over a certain period. The Stochastic ranges from 0 to 100 levels. Below 20 represents an oversold market, and above 80 reflects an oversold market.
Relative Strength Indicator (RSI)
The RSI is one of the most common technical indicators. It is used to identify overbought and oversold conditions, price momentum and reversals. The relative strength indicator is shown as levels from 0 to 100. The RSI signals an overbought market by breaching 70, while lower than 30 indicates an oversold market.
How to Trade Divergence?
The main purpose of divergence is to recognize the imbalances between price movements and technical indicators, assuming that imbalances signal potential changes in price trends.
Despite being insightful when it comes to detecting price directions, divergence should be integrated within a full technical analysis to confirm its reliability.
Here are some tips for trading divergence:
- Detect the overall price trend for the traded asset.
- Identify resistance and support levels.
- Spot divergence by comparing the oscillator’s movements to price movements.
- Define whether it is a bullish or bearish divergence.
- Use a comprehensive price analysis to detect entry signals for your trade.
Divergence Vs Confirmation
While divergence happen when prices and indicators move in different directions, the confirmation is when both prices and indicators move in the same direction. Confirmation is an affirmative sign that the current trend is gaining momentum and is likely to continue.
Divergence is when the price is moving in the opposite direction of a technical indicator like RSI, oscillator or MACD. It is a very powerful signal in forex technical analysis and can efficiently signal a price reversal.
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