Did you ever buy during a breakout or a pullback in a solid uptrend only to see price reverse on you, taking out your stop? Or sell when you were sure the price was ready to move down from a resistance level only to then watch as it reached new highs?
One way you can avoid this experience is by examining market internals to learn whether market strength is improving or deteriorating. If strength is improving, the current trend tends to continue; if not, it often doesn’t. There are several tools for doing this but many of them, such as volume and the advance/decline line, are not suited for the Forex market.
A way that we Forex traders can assess market strength is to watch our indicators for something called confirmation. Momentum indicators are especially valuable for this—RSI, MACD, ROC, and Stochastic among others. Confirmation occurs when your indicator is moving in the same direction as price. If price is moving up, your indicator should be moving up. If price is moving down, the indicator should be moving down.
If it’s not—if it’s flat or going in the opposite direction from price, you have divergence. Divergence can occur more than once or go on for a time before price reverses. An early warning of a potential trend change, divergence doesn’t guarantee the trend will change. It’s a hint that you should watch price action carefully before placing a trade. For example, if you see divergence and also see a break of a trend line, you might hold off on buying.
In the following daily chart of GBPUSD, from March until June both price and RSI were in an uptrend. RSI was confirming the trend. But in June RSI started to diverge—it began to go in the other direction. I’ve shown this with the red down sloping line over RSI.
Notice that when it did start to diverge that price went into a sideways congestion area. At the end of July, price broke above this congestion. Had you been quick you could have still made a nice little profit, but since many traders wait for a close above the breakout line, they would have bought almost at the high. After the breakout candle, price reversed and has been in an overall down trend since then. The same fate would have awaited those who bought on the pullback to the green uptrend line. The subsequent price reversal would probably have stopped you out before you saw any profits. In both cases, the divergence was a clue that the market internals were weak.
In the example above, the divergence is bearish. It can also be bullish. For example, if price is headed down and the indicator is headed up, you might look closely for other buy signals rather than go short. Whether bullish or bearish, divergence suggests a potential change in the price action. It signals the trader to watch the price action carefully before placing a trade.
© Dianne Fecteau, 2009.