What is Divergence?
Can it make you better at trading?
If you have been trading for a while, you have probably heard the term divergence.
It is not something you will get to see frequently on a trading chart.
But if it does appear in front of you, you should be very careful, because it can indicate
a possible change in the direction of the current trend.
To understand how the divergence can help us in trading, we will first have to understand
what divergence is.
The disagreement between an indicator and the price movement is called divergence.
In simple words, Divergence occurs, when the price is saying one thing, but the indicator
is indicating something else.
Let me explain.
Usually, in an uptrend, you will see oscillators and the price indicating the same direction
of the trend.
You can tell this by connecting the higher highs of the price and the higher highs of
the oscillators.
On this chart both the indicator and the price, are making higher highs.
Or in other words, the oscillator looks very similar to the price movement of the chart.
But sometimes, you will see something like this.
Here, if you try to connect the higher highs of the price and the indicator, you will notice
that you can successfully connect the higher highs of the price, but the oscillator does
not have a higher high.
It has made a lower high.
It has made a move that is not similar to the movement of the price.
This is what a divergence looks like.
Now They are two types of divergence.
When price makes higher highs, but an oscillator makes a lower high, it is called a negative
divergence.
Similarly, In a down trend, when price makes lower lows, but the oscillator makes higher
lows, it is called a positive divergence.
But how can this information be useful?
If we see a divergence while trading, what should we do?
Well, here are few things we can do.
When divergence occur, there is a chance that the trend can reverse, or go sideways.
In an uptrend, if you see a negative divergence, there is a high chance that the uptrend will
turn in a sideways trend, or go in the opposite direction.
If you have a position open, you should maybe consider closing it, or setting a stop loss,
because there is a chance that the price will stop moving further in your favor.
If you were thinking about taking a long position, it is good idea to wait a bit, as price can
go lower.
In a downtrend, If you see a positive divergence, there is a high chance that downtrend will
end soon, and it will be a start of a new trend.
If you are already in a short trade, make sure you watch it closely, and adjust your
stop loss carefully, as the price can go in the opposite direction.
And if you were thinking about taking any short trades, maybe consider watching the
price movement from the sideline, and wait for a better entry condition, where there
is no divergence.
Now, a lot of people, will tell you to take trades in the opposite direction of the trend
when the divergence occur.
I don't recommend it, because there is a big problem with taking trades like that.
You see, when you spot a divergence, price won't immediately go in the opposite direction.
It can continue to move in the same direction, before finally changing the trend direction.
And when it will change the direction, there is no guarantee that it will go in the opposite
direction.
The price can simply go sideways for a while, and can continue to move in the same direction
as it was before.
So, what's the use of the divergence then?
Well, divergence is not that good when it comes to trade entries, as the exact time
of the direction change is difficult to predict.
But what you can do when divergence appear, is to avoid taking new trades, and adjust
the stop loss of your open trades.
Here's an example.
Lets say, you are in an uptrend for a while.
In this uptrend, you spot a negative divergence.
Now you have more information on the trend direction.
Now you know that there is a chance that it can reverse.
With the help of this new information, you either close you long position and book a
profit, or you adjust the stop loss to break even, so that you won't lose money if the
price comes down.
Now, what indicators are the best to spot divergences on a chart.
Well, RSI, MACD, CCI, money flow index and Awesome Oscillator are great to spot divergence
on a trading chart.
To keep things simple, you can use RSI or MACD.
Here's how divergence looks on these indicators.
As you can see, a good divergence can be easily spotted on all of these indicators.
If you want to spot divergence while trading, you don't have to look at every single one
of these indicators.
Using MACD or RSI will get the job done.
Here are some important points to remember about trading divergence.
Number 1.
You should not trade with divergence alone.
You should use it with other indicators.
Divergence should be used to analyse the price movement better.
Number 2.
Divergence won't appear for every price reversal.
Number 3.
If divergence occur, it does not mean that price is going to reverse, it can simply go
sideways.
Number 4.
It is very difficult to spot the exact timing of the reversal once you spot the divergence.
Number 5.
If you spot a divergence, maybe consider closing or adjusting your open positions, as price
can stop moving further in your favor.
Number 6.
It is better to not act on divergence that are spotted in a range market.
Number 7.
It is not an entry signal generator, so don't use it as one.
Think of divergence like this.
Lets say, You are driving a car.
When you step on the accelerator, the car goes faster, but the speedometer goes down.
As you can see, there is a disagreement between the actual speed of the car, and the speedometer
that is indicating the speed.
This hints that there is something wrong with the car, or with the world the car is driving
in.
Similarly, when you see the price movement, and an indicator on a chart at a disagreement,
you simply wait, until you see them in an agreement.
That's all.
That's what Divergence is all about.
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