Trading Divergence
Divergence is essentially just comparing price action to the movement of an indicator, when we observe a discrepancy between the price action and the indicator this is known as divergence. The most common indicators traders use for divergence are RSI & MACD.
Divergence is implemented into a trading strategy to spot a possible trend reversal.
There are two types of divergences: bullish and bearish.
Bullish Divergence
Bullish divergence occurs when the price reaches a lower low but your indicator reaches a higher low.
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This normally occurs at the end of a DOWNTREND.
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In this example we will be using the RSI indicator to identify divergence.
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Bearish Divergence
Now, bearish divergence occurs when price makes a higher high but the indicator fails to make a higher high.
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This divergence can be found at the end of UPTREND. After price reaches its higher high, if the indicator doesn't make a higher high, then we can expect price to reverse to the downside.
How to Trade Divergence
In this example we are going to be looking at USD/CHF and using the Stochastic Oscillator to identify the divergence.
We can see from the chart below that USD/CHF has been in a down trend and is showing possible signs of reversal. Price has made a lower low but the indicator has failed to make a lower low.
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So is it time to buy?
As you can see from the chart above price reversed, broke the down trend and has now started up trending.
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Divergence can be strong indication of a possible reversal of a trend but isn't a stand alone trading strategy. We recommend implementing this into your existing trading plan or at least combining it with other aspects of technical analysis such as support and resistance.