Divergence Trading: Spotting Reversals In Forex Markets

Divergence Trading: Spotting Reversals In Forex Markets – Some currency traders consider oscillator divergences to be the holy grail of technical analysis. Others find these elusive chart patterns to be almost useless. The truth probably lies somewhere in the middle.

The purpose of a classic divergence is to recognize a technical imbalance between price and an oscillator, provided that this imbalance signals an impending change in price direction.

Divergence Trading: Spotting Reversals In Forex Markets

In the following paragraphs, we will explain two trades that were made due to several MACD histogram divergences appearing on the daily USD/JPY charts. The first deal turned out to be a dream. The second left much to be desired.

Trend Reversal Strategy (backtest)

As you can see in the daily dollar/yen chart in Figure 1, these two divergence signals occurred relatively close together, between the last months of 2006 and the beginning of 2007.

For the first signal (indicated in dark red), which occurred between November and December 2006, we have an almost textbook case of a classic bullish divergence. Price made a sharp lower low while the MACD histogram made a very obvious higher low. According to proponents of divergence trading, this type of price oscillator imbalance heralds a price correction of the imbalance. In this case, the price correction should have been an upward reversal.

That is exactly what happened. Like clockwork, as you can see from the chart above, the price turned up in early December and didn’t look back until the second divergence ended.

This first divergence signal was so strong that there was even a mini-divergence (shown in dark red dotted lines in Figure 1) within a larger divergence that helped confirm the signal to go long. Fortunately, the subsequent bull move was caught as a result of the early detection of this very clear divergence signal. Anyone who caught this particular divergence play was richly rewarded with almost immediate profits. Below we will explain the method I used to trade.

Chart Art: Trend And Reversal Setups On Nzd/usd And Aud/jpy

The second divergence signal (indicated in dark blue), which occurred between mid-December 2006 and mid-January 2007, is not a typical signal. While the contrast between the two peaks at the lower high of the MACD histogram was indeed extremely marked, the price action was not so much a direct higher high as one continuous uptrend. In other words, the price portion of this second divergence did not have such a sharp edge in its peaks as the first divergence did in its well-defined troughs.

It is difficult to say whether this signal imperfection was the cause of the less than outstanding results that followed immediately. Any currency trader who tried to play this second divergence signal and then sell short was hit pretty hard in the days and weeks that followed.

However, the exceptionally patient traders whose last stop losses failed were rewarded with a near-high selling opportunity that turned out to be almost as impressively profitable as the first divergence trade. The second divergence trade didn’t do much in terms of pips. However, this second divergence certainly signaled a very significant top, just as the first trade in the divergence signaled a low.

So, how can we best maximize the potential profit from a divergence trade while minimizing the associated risks? First of all, although divergence signals can work on all timeframes, longer term charts (daily and above) usually produce better signals.

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In terms of entries, once you find a highly probable oscillator divergence trading opportunity, you can scale the position using fractional sized trades. This avoids too much commitment if the divergence signal is immediately false. If a false signal does occur, stop losses are always in place—not so close that minor reversals knock you out, but also not so loose that a favorable risk/reward ratio is skewed.

On the other hand, if the trade becomes favorable, you can continue scaling until the estimated trade size is reached. If the momentum continues to exceed this value, you should hold the position until the momentum slows down or something more than a normal pullback occurs. The moment the momentum wanes, you then scale the position, making progressive profits from your fractional trades.

If the choppy, aimless market drags on, as in the case of the second divergence signal described above for the USD/JPY pair, this should encourage you to lower your risk and go looking for the best divergence trade.

It’s safe to say that oscillator divergence signals have at least some value, at least in the foreign exchange market. If you look at the recent history of major currency pairs, you will see a lot of similar signals on long-term charts (such as daily charts) that can provide concrete evidence that divergence signals are often extremely useful.

Divergence Pattern Explained: Understanding The Basics

The proposals presented in this table come from partnerships from which they receive compensation. This compensation may affect how and where ads appear. does not include all offers available on the market. If you follow us regularly, you must have noticed how often we use the word “divergence” in our analyzes, usually when a trend reversal is expected. Divergence occurs when the price reaches a new extreme, while the indicator line, which measures the strength of the price movement, does not. This means that despite a new high or low, the current trend is exhausted and may end soon. Oscillator indicators are the best tool for spotting divergence. In our opinion, the Relative Strength Index or RSI, MACD and Momentum are the best.

Technical analysis is best understood by looking at a chart, so let’s get right to it. Below is a bearish divergence with the RSI between the last two Bitcoin highs.

In this case, Elliott Wave analysis suggests that we should be ready for a significant pullback as every five-wave impulse is followed by a three-wave correction. The bearish odds were further improved by the RSI, allowing us to recognize a bearish divergence between waves (v) and waves (iii). Wave (v) surpasses the top of wave (iii) in price, but the RSI does not reach a new extreme. This is a discrepancy. The chart below shows what happened to the price of bitcoin next.

Bitcoin fell from $1,350 to $891 following the SEC’s decision to halt the creation of two Bitcoin ETFs. Fortunately, the Elliott Wave and the RSI divergence warned us of this. This is how you spot divergence in an uptrend. The GBPCAD chart below shows the MACD divergence in a downtrend.

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This time, the five-wave pattern was pointing south, so a three-wave correction was expected to push the pair higher. In addition, the MACD indicator made a double bullish divergence visible. As you can see, the lowest bottom of the indicator corresponded to the low of wave (3) of III. It failed to reach new depths in waves (5) of waves III and V, suggesting that a major recovery will follow.

GBPCAD rose from 1.5736 to 1.7339, giving us another reason to keep using oscillators to support our analysis. But does this mean that we can use divergence as a trading signal? Absolutely not. Determining tops or bottoms remains extremely risky, no matter how many indicators indicate that the trend is about to change direction. The examples shown above can be very impressive, but keep in mind that the market can always ignore technical indicators and just keep moving in the same direction. I doubt? Take a look at the chart of the German DAX index.

The DAX continues to rise even though the RSI started to diverge three months ago. This is why traders should not base their trading decisions solely on indicators. All they do is

That the current trend is fading. The detection of a discrepancy does not mean that the road is closed. It’s more like a “proceed with caution” or “ignore at your own risk” sign.

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