Forex Divergence Strategy

Christopher Lewis

Learning how to spot divergence on a Forex price chart can improve the profitability of your trading. In this article, I explain what divergence and its several sub-types are, how to best trade it, and how effective it tends to be as a sign to watch in Forex trades.

 

What is Divergence?

Divergence in Forex is quite often used to indicate the possibility of a trend change. Divergence can be found using various indicators, all of which are in the oscillator family. These include the MACD indicator, RSI, and others. The term “divergence” refers to when an oscillator shows a difference between momentum and price action. For example, if the value of the oscillator shows that the momentum of the market is shrinking while the price is rising, that is an example of divergence. This shows that the underlying momentum may be dropping, and therefore a lack of buying interest may come into the picture.

Divergence is used by traders on multiple time frames, but as with most technical analysis in Forex, it does tend to perform better on higher time frames. This makes sense considering that it takes so much more effort and trading volume to form a candlestick pattern or individual candlestick on a weekly chart than something smaller such as a five-minute chart. Furthermore, it should be noted that divergence typically is not in and of itself a reason to take a trade, but it gives you a bit of a “heads up” as to when to look out for a potential trade entry’s appearance. Most often, traders will find divergence on the chart and then look for their favorite candlestick set up or a break of support or resistance before making the final decision to execute a trade entry which is supported by the divergence.

How to Trade Divergence in Forex

In the price chart below, I present a daily chart of the USD/CHF currency pair. You can see that the chart has a large circle drawn at the top, where the market put in a top. Underneath, the MACD (Moving Average Convergence Divergence) indicator is highlighted by a large rectangle. Note that the moving averages that are part of the indicator have started falling from their absolute highs, while at the same time the price is rising. Furthermore, the histogram, which is the green and red bar pattern in the center, has gone from positive to negative while price continue to rise. This is divergence.

This situation suggests that perhaps the underlying momentum of the market is starting to fail a bit, which can be a warning that we may not be able to continue the overall move to the upside. While this is not necessarily a signal itself, it gives you yet another reason to think that maybe a sell signal would be worthwhile. In this case, it just so happens that there is significant support near the 0.9250 level and breaking down below that level further confirms that the trend is coming to an end and reversing.

MACD Divergence

This is a good example of how to trade divergence in Forex conservatively: wait for a divergence which is confluent with a reversal at a key support or resistance level.

Types of Divergence in Forex

When it comes to divergence, there are two different main types.

Negative Divergence

“Negative divergence” (otherwise known as bearish divergence), is what the previous example in the USD/CHF pair demonstrated. This shows that momentum is falling, and perhaps a negative move is about to happen.

Positive Divergence

“Positive divergence” (also known as bullish divergence), is when momentum is picking up, but the price is weak at a low. This tends to suggest that the market is ready to make a turnaround and go bullish.

Examine the price chart below. It features the GBP/JPY pair and features positive divergence. The RSI sits down at the bottom and shows that momentum was starting to pick up before price did. In fact, we formed a little bit of a “double bottom” at the ¥127 level, but even as the price started to slump, the line on the RSI was rising. This was a hint, along with the double bottom, that we could continue to go much higher. As you can see, it triggered a major rally that eventually went all the way to the ¥148 level.

RSI Divergence

Hidden Divergence

There is also such a thing as “hidden divergence.” Typically, this is divergence between an oscillator and price action, but shows a likely continuation of the longer-term trend rather than a trend reversal. For example, if the market had been pulling back for a while and the oscillator started to show signs of bullish momentum, then it could show that the market was ready to continue the overall longer-term trend. This is essentially the same thing as “positive divergence” in what would have been a longer-term uptrend after a pullback. While it essentially means the same thing, it is important to note that sometimes people call this “hidden divergence” instead of positive divergence.

Check out the AUD/USD weekly price chart shown below. In the circled area and the part of the MACD that is highlighted by a rectangle, you should be able to see that several things are going on. For example, from a candlestick pattern perspective alone, we have formed a massive “W pattern”. This of course is very bullish. However, the market had pulled back quite significantly from a previous uptrend. Notice how the divergence on the oscillator showed itself by the histogram and the moving averages both have been rising while the price had pulled back for several candlesticks, roughly equivalent to two months. This was a sign that the longer-term uptrend was ready to continue. However, you could just as easily call this “positive divergence”, instead of “hidden divergence”, because essentially it is the same thing. Obviously, this can happen in both directions, but it must be along with the overall prevailing trend to qualify as hidden divergence.

Hidden Divergence

How Effective is Divergence in Forex?

Divergence is a common strategy and therefore it is relatively effective in the currency markets.

You need to be very cautious about taking a trade only based upon divergence.

Like anything else in technical analysis, it tends to be much more effective on longer-term charts, and it most certainly needs to be backed up by other signs of confluence to take a trade.

Yes, it can work on its own but at the end of the day when you look at these examples, you can also see that there were other factors worth paying attention to at the same time, mainly a break of support or resistance.

It should also be noted that divergence is a very common tactic in stock trading, commodity trading, and other financial markets. It can be applied to any kind of underlying asset, so it is a type of trading that you can use regardless of where you are putting money to work.

Conclusion

Divergence is a useful tool to have when trading currencies, or any other markets for that matter. It is best thought of as a bit of a “early warning system” for beginning the process of entering a trade. Not only can you use it for a potential trade of a trend reversal, but if you are already part of a trend, it can give you a little bit of a heads up as to when you may need to either tighten your stop loss or take profit order. So, it can also be used to help you spot an optimal trade exit.

One of the more important aspects of divergence is that it is so widely used, many other traders will be paying attention to as well. Because of this, it is something that even if you choose not to trade this as a strategy, you should at least know divergence exists, because when it is obvious it can help move a market.

FAQs

How do you detect Forex divergence?

The signs of divergence in Forex can be found with any type of oscillator, but the most popular ones to use are the RSI and the MACD. You can also use other oscillators, but these are by far the two most popular. It simply a matter of seeing when momentum is moving in the opposite direction of price. In that sense, any momentum-based oscillator can work, but you should probably avoid some of the more exotic oscillators, simply because you are hoping that other traders around the world are seeing the same type of set-ups you are.

How accurate is divergence trading?

It is just as accurate as anything else and is best combined with other confluent indications for a trade entry signal. The best thing about divergence is that it is not only accurate for a potential trend change, but it also gives you something to pay attention to for managing an existing trade. In other words, if you are seeing divergence on the chart that is working against your interests and your trade set up, it could give you a bit of an indication that you should start thinking about taking profit.

What is the best indicator to show divergence?

This is a very personal choice. I like the MACD, but the best thing you can do is find an oscillator indicator that you truly believe in. I have seen people use the Commodity Channel Index, as well as the Force Index. The choice is yours, but all these setups work in the same way.

Christopher Lewis

Christopher Lewis has been trading Forex for several years. He writes about Forex for many online publications, including his own site, aptly named The Trader Guy.

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