Trading with Divergences

[RichardCox 10]

Trading with Divergences

 

Since most practitioners of technical analysis plot indicators and oscillators on their charts, it makes sense to have an understanding of the instances where prices diverge from the signals these technical tools are sending. Most indicator tools will generate trading signals in three different reforms: signal line crossovers, center line crossovers, and in price divergences. Divergence signals are the most complicated of the three, and occur when prices and the indicator are moving in opposing directions.

 

Bearish divergences are seen when prices are trending upward but the indicator -- such as the Relative Strength Index (RSI), Rate of Change (ROC), or the Moving Average Convergence (MACD) -- is falling. This essentially indicates that the uptrend is losing momentum and further gains are unlikely to sustain themselves. In contrast, Bullish divergences are seen when prices are in a downtrend and the indicator begins moving higher. This is a signal which suggests that traders in sell positions should exit before prices reverse higher. For these reasons, divergences should be thought of as reversal signals, and one of the greatest benefits of trading these occurrences is that they allow you to buy at cheap prices (in the midst of downtrends) and sell at expensive prices (when prices are still trending upwards).

 

Criteria for Bullish Divergences

 

It should be remembered that divergences can occur over long time frames, so it makes sense to look for additional signals (such as a trendline break, or a violation of support or resistance levels) in order to help confirm the reversal. In the first chart example, we can see a classic bullish divergence, where prices have posted consistent lower lows. This downtrend, however, is not supported by the indicator reading, as it moves upward and posts higher lows in the process. For trades, this information can be used in one of two ways. First, for traders that are already long, it would make sense to close the position and take profits (as there is now evidence that the uptrend is ready to stall). For those looking to enter into contrarian positions, long trades can be taken once the downtrend line that defined the previous decline in broken, or when resistance levels on short term time frames are invalidated.

 

Criteria for Bearish Divergences

 

In the second charted example, we see an arrangement that is indicative of a downside reversal, the classic Bearish divergence. Here, we can see a general uptrend, with prices posting a clear series of higher highs. For those using a breakout strategy, it might have been easy to get sucked into entering into long positions at the upper levels. But if that breakout trader paid attention to the activity seen in the indicator, caution would have been warranted and potential losses could have been avoided. Specifically, the indicator reading can be seen posting lower highs, are prices are reaching new peaks. Traders already long should have booked profits at this stage, as this is now a clear indication that the uptrend has run its course and is vulnerable to corrective downside reversals.

 

For those looking to employ contrarian strategies, this contrast between price behavior and the more objective indicator reading means that a sell signal is in place. This signal is confirmed once short term support levels or broken or when prices fall below the previously established uptrend line. This would suggest that lower lows are now in place, the bull move has reached its end, and that the climate is right for new sell positions. The main benefit of these trades (especially when compared to trend trading or breakout strategies) is the fact that you would be able to short the currency pair when prices are trading well above their recent historical averages. This essentially means that there is much more downside risk than upside potential and taking trades in these areas tend to have a higher probability for success when compared to breakout strategies.

 

Stop Losses and Profit Targets

 

When taking trades based on divergences, the placement of stop losses is a relatively simple process. Since a buy or sell position is based on the assumption that the previous trend is reversing, all you will need to do is place your stop loss in an area that invalidates the pattern. For example, if you are trading a bearish divergence, simply find the highest peak in the previous uptrend and place your stop at least ten pips above it. The reasoning here is that if prices were to hit your stop loss area, the prior uptrend was really not over and the divergence condition seen in the indicator was not an accurate reflection of the underlying momentum seen in the market. Stop loss logic for bullish divergences is relatively similar, only in reverse. In these cases you will want to place your stop below the lowest trough that marked the previous downtrend.

 

For profit target levels, we need strategies that are a bit more in depth because we cannot simply look at the old highs and lows from the previous trend. Alternatively, it makes sense to look at the prior trend and draw Fibonacci retracements that are measured from those moves. For example, once you have spotted a confirmed bullish divergence and taken a long position on the anticipated reversal, measure your Fibonacci levels on that move and set your profit targets at the 61.8% Fib retracement, as explained here. In the case of a bullish divergence, the 61.8% Fib retracement of the prior downtrend will likely act as strong resistance that could prevent further gains. More conservative traders could use the 38.2% Fib retracement of the same move and take partial profits (and then move stops to break even). For bearish divergences, the same levels could be used, as the 61.8% retracement is likely to act as strong support and prevent further losses.

 

Failed Divergences

 

Of course, no technical strategy is foolproof and it is important to look for possible reasons the divergence is failing once positions are taken. This will enable you to close the position before large losses are seen. If for example, the indicator reading re-adjusts and shows agreement with the prior trend (after the divergence is spotted), the position can be closed as the original rationale behind the trade is no longer valid. In other cases, it is important to watch critical support and resistance levels. If you spot a bullish divergence, take a long trade and then see that prices have fallen to new lows, it no longer makes sense to hold onto the short position.

 

This is because your reasoning behind the trade was based on the assumption that the initial downtrend was over. If prices fall to new lows, you will know that this is not actually the case and that you should not be in the position. The same strategies hold true for bearish divergence, only in these cases you will be looking for instances where prices are hitting new highs. This would indicate the initial uptrend is still valid and that the majority of the market’s momentum would make short positions excessively risky.

 

Conclusion: Disagreeing Price and Indicator Readings Suggest Reversals are Imminent

 

Trading Divergences can be useful both for those looking to establish new positions or close existing positions once a major trend has run its course. Under ideal trading conditions both indicator readings and price behavior will unfold in perfect agreement. But, when this is not the case (and divergences are seen), warning signals should flash on the possibility of a major reversal. The most accurate divergences are seen in conjunction with other signals (such as a trendline break, a move past support or resistance or an accompanying price pattern).