4 Divergence Trading Strategy Explained

Divergence trading is popular and a type of trading strategy used in the financial markets to identify potential trend reversals or continuations. It involves identifying divergences between price action and technical indicators, which can signal a change in market sentiment or momentum.

In trading, A divergence occurs when the price of an asset and an indicator used to analyze that asset and its price movement move in opposite directions. For example, if the price of an asset is making higher highs while the indicator is making lower highs, this is a bearish divergence and may suggest that the price will soon reverse to the downside.

The ideology of divergence trading has been around for a long time and was first introduced in the early 20th century by Charles Dow, the founder of the Dow Jones Industrial Average. Dow believed that the stock market moves in a series of trends and that these trends could be identified by looking at the relationship between the Dow Jones Industrial Average and the Dow Jones Transportation Average.
Since then, divergence trading has evolved and is now widely used by traders in various markets, including forex, stocks, and commodities.

Traders use a range of technical indicators to identify divergences, including moving averages, oscillators, and momentum indicators.

Divergence trading is a useful tool for traders to identify potential trend reversals or continuations. However, like all trading strategies, it has its limitations and should be used in combination with other technical and fundamental analysis techniques.

Why Divergence Trading is Important and a Brief Overview of
this Post

Divergence trading is important for several reasons, especially for traders who want to identify potential trend reversals or continuations in the financial markets.

7 importance of divergence trading and a brief overview of the key points to be covered.

1. Divergence trading helps traders to identify potential trend reversals or continuations. By identifying divergences between price action and technical indicators, you can get a better understanding of market sentiment and momentum.
   For example, a bullish divergence may suggest that the price of an asset is likely to reverse to the upside, while a bearish divergence may indicate that the price is likely to reverse to the downside.
2. Divergence trading can be used as a standalone strategy or in combination with other technical analysis tools. You can use a range of technical indicators to identify divergences, including moving averages, oscillators, and momentum indicators.
   By combining divergence signals with other technical analysis tools, traders can increase their confidence in their trading decisions.
3. Divergence trading can help traders to manage risk. By identifying potential trend reversals or continuations, traders can set appropriate stop-loss orders and limit orders to manage their risk and protect their profits. This can help traders to minimize their losses and maximize their gains.
   In this post, we will discuss the types of divergence, how to identify divergence, how to trade with divergences, and examples of successful divergence trades.
   We will also discuss the importance of diversifying trading strategies and the risks involved in trading.

Types of Divergence

Like, I said earlier, there are four types of divergence we are going to discuss, they are Regular bullish divergence, Hidden Bearish Divergence, Regular Bearish Divergence, and Hidden Bullish divergence. We are going to discuss them one after the other.

Regular bullish divergence

Regular bullish divergence is a type of divergence that occurs when the price of an asset is making lower lows while the technical indicator used to analyze the asset of price movement is making higher lows. What this means is that the momentum of the price is weakening, even though the price is still making lower lows. It may suggest that the price will soon reverse and start moving upwards.

Let us take for example, say the price of a stock is in a downtrend and is making lower lows.
However, the relative strength index (RSI) indicator is making higher lows. This suggests that even though the price is still moving downwards, the momentum of the price is weakening, and the price may soon reverse and start moving upwards.

Regular bullish divergence is a powerful signal for you as it can provide an early indication of a potential trend reversal. You can use this signal to enter long positions in anticipation of the price reversing and moving upwards. However, I will advise you to note that regular bull divergence should not be used as the sole basis for making trading decisions. You should use it in combination with other technical and fundamental analysis tools to confirm your trading decisions.

Hidden bearish divergence

Hidden bearish divergence on the other hand occurs when the price of an asset is making lower highs while the technical indicator used to analyze the asset price movement is making higher highs.
This indicates that the momentum of the price is weakening, even though the price is still making lower highs. It may suggest that the price will soon reverse and start moving downwards.

Hidden bearish divergence is a powerful signal for traders as it can provide an early indication of a potential trend continuation in a downward direction.
Most traders use this signal to enter short positions in anticipation of the price continuing to move downwards. You should use it in combination with other technical and fundamental analysis tools to confirm your trading decisions.

Regular bearish divergence

Regular bearish divergence takes place when the price of an asset is making higher highs while the technical indicator used to analyze the asset price movement is making lower highs. What this indicates is that the momentum of the price is weakening, even though the price is still making higher highs.
It may suggest that the price will soon reverse and start moving downwards.

This suggests that even though the price is still moving upward, the momentum of the price is weakening, and the price may soon reverse and start moving downwards.
Regular bearish divergence should not be used as the sole basis for making trading decisions.
They should be used in combination with other technical and fundamental analysis tools to confirm their trading decisions.

Hidden bullish divergence

Hidden bullish divergence happens when the price of an asset is making higher lows while the technical indicator used to analyze the asset price movement is making lower lows.
The indication is that the momentum of the price is strengthening, even though the price is still making higher lows. It may suggest that the price will continue to move upward.

For example, let us say the price of a stock is in an uptrend and is making higher lows. The (RSI) indicator, however, is making lower lows. This suggests that even though the price is still moving upward, the momentum of the price is strengthening, and the price may continue to move upwards.

Identifying Divergence

We are going to discuss how to identify Divergence, we will equally analyze Tools and indicators for identifying divergence, furthermore, we will understand How to read and interpret divergence signals and the Importance of combining divergence signals with other indicators

Tools and indicators for identifying divergence:

Relative Strength Index (RSI): This is one of the most popular indicators used by traders to identify divergence. The RSI measures the momentum of an asset price movement and it is a useful tool for identifying overbought and oversold conditions.

Moving Average Convergence Divergence (MACD): This indicator is used to identify trend direction and momentum. It is deduced by subtracting the 26-day exponential moving average
Exponential Moving Average (EMA): from the 12-day EMA to the 21-day EMA
Stochastic Oscillator: This indicator is used to measure the momentum of an asset price movement. It computes and compares the closing price of an asset to its price range over a certain period of time.

Importance of combining divergence signals with other indicators:

While divergence signals can be a useful tool for identifying potential trend reversals or continuations, it is important to use them in combination with other technical and fundamental analysis tools.

Combining different indicators can help confirm trading decisions and provide a more complete picture of an asset price movement. It is important to consider other factors such as market trends, economic news, and the company’s financials when making trading decisions.
We shall now discuss how we can Trade with divergence.

Trading with Divergence

Divergence signals can be used to make several types of trades. Here are some of the most common ways to trade with divergence signals:
Reversal Trades: Divergence signals can be used to identify potential trend reversals in the market. For example, if a regular bullish divergence is identified, it can suggest that the current downtrend is losing momentum and that a reversal may be imminent.

A trader could use this signal to enter a long position in anticipation of the price turning upwards.
Continuation Trades: Divergence signals can also be used to identify potential trend continuations. Let us say if a hidden bearish divergence is identified, it can suggest that the current uptrend is losing momentum and that a continuation of the downtrend may be imminent.

A trader could use this signal to enter a short position in anticipation of the price continuing to move downwards.
Confirmation Trades: Divergence signals can be used to confirm other technical analysis signals. For example, if a trader identifies a potential trend reversal through a chart pattern or a moving average crossover, they could use a divergence signal to confirm their analysis before entering a trade.

Exit Trades: Divergence signals can also be used to exit a trade. For example, if a trader is in a long position and identifies a regular bearish divergence, it can suggest that the price may soon reverse and start moving downwards.
The trader could use this signal as a cue to exit the long position to avoid potential losses.

Entry and exit strategies for divergence trades

Entry and exit strategies for divergence trades can vary depending on the trader and individual’s trading style and risk management approach.
Here are some commonly used strategies for entering and exiting trades based on divergence signals:

Entry Strategies:
Wait for confirmation: you can wait for confirmation of the divergence signal by using other technical analysis tools, such as chart patterns or support and resistance levels, before entering a trade. This can help to reduce the risk of false signals and improve the chances of a successful trade.

Use multiple timeframes: you can use multiple timeframes to identify divergence signals, and then use the signals from the higher timeframe as confirmation before entering a trade on the lower timeframe. This can help to filter out false signals and increase the accuracy of trades.
Use multiple indicators: you can use multiple indicators to identify divergence signals, and then use the signals from multiple indicators as confirmation before entering a trade.
This can help to increase the reliability of the signal and improve the chances of a successful trade.

Exit Strategies:
Use stop-loss orders: Traders can use stop-loss orders to limit their losses in case the trade goes against them. A stop-loss order is an order to sell a position if the price falls to a certain level.
This can help to protect the trader’s capital and limit their risk.

Use profit targets: Traders can use profit targets to take profits on a trade when the price reaches a certain level. This can help to lock in profits and avoid the temptation to hold onto a winning trade for too long.

Use trailing stops: Traders can use trailing stops to protect their profits as the price moves in the trader’s favor. A trailing stop is a stop-loss order that is adjusted as the price moves in the trader’s favor.
This can help to lock in profits and avoid giving back gains if the price suddenly reverses.

Risk management for divergence trades

Risk management is a crucial aspect of any trading strategy, including divergence trading. Here are some tips for managing risk when trading with divergence signals:

Use appropriate position sizing: Position sizing refers to determining the size of your trade based on your account balance and risk tolerance. You should avoid risking too much of your account on any single trade, as this can lead to significant losses if the trade goes against them.

A general rule of thumb is to risk no more than 1-2% of your account balance on any single trade.
Set stop-loss orders: Stop-loss orders are orders to sell a position if the price falls to a certain level. Setting a stop-loss order can help to limit your losses if the trade goes against you.
You should place your stop-loss orders at a level that makes sense based on the technical analysis and risk tolerance.

Use proper leverage: Leverage can amplify both profits and losses in trading, and you should be cautious when using leverage. Using too much leverage can result in significant losses if the trade goes against you.
It’s important to understand the leverage offered by your broker and use
it appropriately based on your risk tolerance.
Avoid trading during high volatility periods: High volatility periods can increase the risk of trades going against you, and you should avoid trading during these periods or adjust your risk management strategies accordingly.

Diversify your trades: you should avoid putting all of your capital into a single trade or a single asset. Diversifying your trades can help to spread out the risk and reduce the impact of any single trade on your account balance.

Monitor your trades: you should monitor trades closely and be prepared to adjust your risk management strategies if market conditions change. This can include adjusting stop-loss levels or closing out trades early if necessary.

Conclusion

In conclusion, divergence trading is a powerful strategy that can be used to identify potential price reversals in the market. By understanding the different types of divergence signals and how to read them, traders can make more informed trading decisions and improve their chances of success.
Some key points to remember when trading with divergence include the importance of combining divergence signals with other indicators, using appropriate risk management strategies to manage your trades, and diversifying your trades to spread out your risk.

Note that divergence trading is just one of many trading strategies available to traders.
By diversifying your trading strategies, you can reduce your reliance on any single strategy and improve your chances of success in the long run.

Overall, while divergence trading can be a powerful tool for traders, it’s important to approach it with a solid understanding of the underlying concepts and a disciplined approach to risk management.
With the right approach and the right tools, traders can use divergence signals to identify high-probability trading opportunities and potentially profit from market movements.