Forex Trading with Divergences

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Forex Trading with Divergences Strategy

Trading using divergences is one of the strategies in forex trading that has a very high statistical edge. This is because divergences allow traders to have a high statistical chance of correctly predicting when the market would be turning. And since we are trading on the turning point of price, we are trying to catch the low of the price when we are buying, or the high of the price when we are selling. “Buy low…sell high!” By doing this, we get to have an opportunity to gain more pips even though we are risking just a fraction of what we could be gaining. This is what makes trading with divergences very powerful.

So, what are divergences? Divergences are basically when the oscillation of the price action on the chart differs from the intensity of the oscillation of the indicator you are using. If you are familiar with price action, you might be familiar with how price forms higher-highs, lower-highs, lower-lows and higher-lows. Oscillators also do this. More often than not, oscillating indicators tend to agree with the price action. If price action forms a higher-high, the oscillating indicator usually forms a higher-high. If price action forms a lower-low, the oscillating indicator should also do the same. Same goes with lower-highs and higher-lows. This should be the usual scenario, the price and the indicator agreeing with each other.

The opportunity then arises when price and the oscillator doesn’t agree. This is because whenever they don’t agree, sooner or later, one must follow suit, and usually it is price. Once this happens, sharp turning points tend to occur. These are called divergences.

Types of Divergences

Now there are four types of divergences: Regular Bullish Divergence, Hidden Bullish Divergence, Regular Bearish Divergence, and Hidden Bearish Divergence. Below is a cheat sheet of the types of divergences.

Regular Bullish Divergence

  • Price Action: Higher-Low then Lower-Low
  • Oscillator Indicator: Lower-Low then Higher-Low

Forex Trading with Divergences 1

Hidden Bullish Divergence

  • Price Action: Lower-Low then Higher-Low
  • Oscillator Indicator: Higher-Low then Lower-Low

Forex Trading with Divergences 2

Regular Bearish Divergence

  • Price Action: Lower-High then Higher-High
  • Oscillator Indicator: Higher-High then Lower-High

Forex Trading with Divergences 3

Hidden Bullish Divergence

  • Price Action: Higher-High then Lower-High
  • Oscillator Indicator: Lower-High then Higher-High

Forex Trading with Divergences 4

If you would have noticed, regular and hidden divergences have their own characteristics. Regular Divergences are more of a major reversal pattern. It signals that a major uptrend or downtrend is about to reverse. This makes regular divergences very lucrative, since when they do occur, a steep change in price usually follows, giving traders the opportunity to earn more pips on a single trade.

Hidden Divergences, on the other hand, are more of a continuation type of patterns. They usually occur on slight corrections of price on a trending market, whether it is an uptrend or a downtrend. This on the other hand allows traders to easily predict where price is heading, since they are trading with the trend. However, caution should still be applied, especially when hidden divergences occur on an extended trending market, which sometimes gives out just a slight push before moving sideways or reversing.

The Trade

The common indicators used with divergences are the usual oscillator indicators, such as MACD. The problem with MACD though is that it usually lags behind price. This causes a little bit of confusion to the traders since the turning points between the price and the MACD is usually not in sync. However, there are others who have found a way to remove the lag of a MACD indicator.

What we will be using instead is the Wildhog indicator. The advantage of this indicator is that, unlike the MACD, it has lesser lag. Also, this type of oscillating indicator shows sharp turning points, which allows us to easily identify the peak and trough of the indicator.

As for the timeframe, this strategy could work for most timeframes, however I would suggest using it on the H4 chart for day trading or swing trading. The reason being that lower timeframes, such as M5 and M15 still has noise, and more often, the divergences turn to be fake-outs.

The Entry

As soon as the indicator shows lines indicating that there is a divergence, and you could confirm as per our cheat sheet above that it could be classified as a divergence, we could then enter the trade.

A slight caution though, since the indicator sometimes shows lines even though it is not the peak or the trough. If this occurs, disregard the lines and don’t take the trade. Yes, these could still work, but they are less reliable. We should be following our definition as to what divergences are and not just follow blindly what the indicator is telling us.

Also, try to be cautious whenever having a setup with a wide stop-loss, due to a long signal candle. Sometimes, with these setups, the reversal might be completed with just a few candles, sometimes even with just one or two. This type of trade is the usual cause of pain for most traders using divergences.

The Stop Loss

Since divergences usually form on a reversal, whether it is a major reversal or just a slight correction, these turning points usually form a fractal, a peak or trough. This is where we should be putting our Stop-Loss. We should place our stop-loss just a few pips away from the newly formed peak (bearish divergence) or trough (bullish divergence).

The Take Profit

For this strategy, we will not be using a hard and fixed take profit. Since this is an indicator based strategy, our Take-Profit would also be based on the indicator. This means that we will be doing manual closing of our trades. We will be closing our trades as soon as the indicator creates a peak or a trough, which signifies that price might be changing direction.

Regular Bullish Divergence Trade

Forex Trading with Divergences 5

Hidden Bullish Divergence Trade

Forex Trading with Divergences 6

Regular Bearish Divergence Trade

Forex Trading with Divergences 7

Hidden Bearish Divergence Trade

Forex Trading with Divergences 8

Conclusion

Trading divergences are very powerful and can gain you lots of pips. The advantage to this is that there will always be an opportunity for trading divergences every day, if you comb through your shortlist of currency pairs that you trade. Not only does this apply to forex trading, this could also be done with other markets, such as commodities, gold, oil, silver, etc. Although this is not a perfect system, it does have its faults and at times get false signals, but divergences, compared to other strategies, have a very high statistical edge. A high win ratio plus a high risk reward ratio. Back-test it yourself, forward-test, and use it.

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