Divergence trading is a well known/well used trading method used across various markets, especially in forex. While divergence trading is not a stand-alone concept of trading, it can be quite useful (and is widely used) as an additional confirmation of a trade signal/set up. In this article, we explain the basics of divergence, how it all started and how you can use divergence techniques to improve your trading system.
Dow Theory – The origin of divergence
Divergence trading is based off the well known Dow Theory, known as Dow Theory Divergence. The Dow Theory divergence analyses the relationship between the DJIA and the Dow Jones Transport Average. Charles Dow compared the Dow Jones Industrials against the transport average and came up with the logic that there was a close relationship between the two. Thus, if one of the two did not move in tandem with the other, ie, if one average reached a peak while the other did not, it indicated a divergence (possibly bullish or bearish).
Divergence trading in Forex
When it comes to the forex markets, divergence is usually compared against price action and an oscillator. When finding out divergence, traders usually make use of any of the following oscillators:-
- Relative Strength Index
When using oscillators, most of the time, the oscillators tend to reflect the price action. Thus is price makes higher highs, then the oscillator should also be making higher highs. Divergence happens when this relationship fails. Oscillators are basically used to identify momentum. As a thumb rule, when momentum increases, prices tend to rise and price falls when momentum decreases. It is this basic definition that has given rise to divergence trading as a good way to confirm a trade set up and subsequently the trade signal as well.
Types of divergences
Divergence can be categorized into the following types:
Bullish Divergence: Bullish divergence is identified when price makes lower lows on the chart, while the oscillator makes higher lows.
Bearish Divergence: Bearish divergence is identified when price makes higher highs on the chart whereas the oscillator makes lower highs.
The above two are also known as Classic or Standard Bullish or Bearish divergence, or Regular Divergence. When any of these two happen towards the extreme low or high in a trend it signals a change. However, be warned that just because a divergence forms does not mean the start of a new trend, in all possibility it could also infer a temporary pause/retracement and so on. Thus, it is essential to use divergence alongside an existing trading system or method. Such types of divergence set ups are formed very often and easy to identify and can be seen from the image below.
Bullish Reverse Divergence: A bearish reverse divergence happens when price action makes lower lows but the oscillator makes a new high.
Bullish Reverse Divergence: A bullish reverse divergence is identified when price action makes a higher high but the oscillator makes a new low.
The above two are commonly referred to as Hidden Divergence or Reverse divergence. The ‘Hidden Divergence’ indicates a continuation of the underlying trend. These kinds of divergences do not happen as frequently as the standard divergences. The image below compares the hidden/reverse Bullish/Bearish divergences.
Divergence trading set ups can be best be illustrated with an example. In the H4 Chart of GBPUSD, you can see an example of a bearish divergence. Price action makes higher lows, while RSI makes a lower low. This indicates a potential fall in price.
The next chart is a continuation of this set up and we notice how price dropped right after we noticed the bearish divergence set up.