Each trader bases his trading on a strategy formed from his personal experience. Some prefer to use fundamental analysis and trade on the news, others - only technical analysis using a standard set of indicators. At the same time, divergence is recognized as one of the strongest and, accordingly, working signals of indicator analysis.
Competent use of classic technical analysis with a combination indicators and considering the news background it is considered the most professional approach to trading. In this article, we will analyze the phenomenon of divergence, which is deservedly considered one of the most powerful signals that helps traders find a point of entry into the market. Let's get acquainted with the reverse signal - convergence and its features. Let's look at erroneous beliefs and cases when divergence gives false signals. The signal rarely appears, therefore its appearance on the price chart deserves close attention. The inconsistency of the behavior of the price chart and the indicator indicates the approach of a possible reversal and, with proper analysis, helps to find profitable entry points to the market with the placement of minimum stop losses.
Forex Divergence and Convergence (definition of terms)
In simple words, convergence in trading is called coincidence of the price chart with the indicator chart, i.e. when on the price chart each subsequent low is lower than the other, and on the indicator chart it is higher.
In simple words, divergence, in trading, is called the difference between the price chart and the indicator chart, i.e. when the price draws new highs, and on the indicator chart, each subsequent high is lower than the previous one.
Both signals are opposite to each other. To detect them on the price chart, we need to set up indicators that are most often used to detect divergence or convergence - MACD, Stochastic, Awesome Oscillator (AO) or RSI.
The use of indicators that mark oversold or overbought zones is not accidental. The very presence of a price chart in these zones in technical analysis is considered a strong signal for a possible reversal. The formation of divergence in such zones is an additional confirmation of their relevance.
In the figure, we see that the appearance of convergence or divergence in Forex is a signal for a reversal of the current trend.
Convergence in Forex and its significance
Convergence is the convergence of the price, that is, the price chart will move towards the indicator chart. In this case, it turns out that each new price minimum will be lower, and on the indicator chart, on the contrary, higher. Both graphs begin to move towards each other or converge (translated from English. "Convergence").
In the picture, we see the convergence of the charts and at the point where the indicator formed a new peak when crossing the line 0, the price reversal occurred on the price chart. The growth was insignificant, but it clearly shows the signal processing.
Features of working with a convergence signal
Convergence is considered a bullish signal or bullish divergence variant that occurs on a falling price chart. May signal an imminent reversal of a downtrend. Many traders distinguish three types of patterns, which differ in the degree of inclination of the angle at which the line of the price chart and the indicator converge. A simple rule works here - the larger the angle of convergence of the lines, the stronger the signal for an approaching reversal of the main trend is considered.
When you get acquainted with the works of famous traders, you can see that in the classical analysis only divergence is defined. It turns out that the divergence and convergence of forex is one signal that is formed by opposite figures and the direction of price movement. Depending on the movement of the chart and indicator, it informs the trader about a possible reversal from bullish to bearish trend or vice versa - from bearish to bullish. Alexander Elder, recognized worldwide as a trading guru, in his book ("The Strongest Signal in Technical Analysis: Divergences and Reversals of Trends") describes the signals of convergence and divergence under the general term - divergence. This makes sense, in fact, the signal is the same, it just differs in the divergence options.
How to use convergence for trading:
- the appearance of a convergence signal does not guarantee a trend change, sometimes it signals us about the transition of the trend to flat, in such situations we say that the signal shows a slowdown in the current trend;
- for the formation of a pattern, the appearance of two tops on the chart is not necessary, a signal of the origin of convergence can be formed on a chart with three tops;
- to confirm the formed convergence, we can use popular technical analysis reversal patterns (head and shoulders, for example). Double confirmation of the emerging convergence signal gives more confidence in the signal strength and the planned trend change.
- if we have an open deal to sell an asset at the moment the signal is generated, then perhaps it is worth thinking about reducing the position or closing, since a reversal is planned.
The main rules for entering a convergence trade:
- the signal must be strong, that is, the angle of divergence between the price of the chart and the indicator, the more the better
- the indicator value is above the 0 mark when working with the MACD histogram;
- the trend line breaks through and the price is fixed below it;
- the reversal occurs at a strong support level.
In the picture I have shown one of the possible options for entering the market during convergence. It is necessary to wait for the formation of a local maximum. Then a signal candle is formed. After it, the next candlestick should fix above the signal one. Here you can open a deal. For more cautious traders, entry is possible at later candles. The stop loss is set at the closing price of the last candlestick before the signal one.
Divergence in Forex
According to the previously mentioned Alexander Elder, divergence is one of the strongest trading signals. Helps to determine the moment of a possible reversal or weakening of the trend and to choose the optimal point for entering the market.
Forex divergence and convergence, we noted earlier, are opposite signals to each other. In case of divergence, there is a discrepancy between the price chart and the indicator chart. In other words, the price chart will move in an upward direction, forming new extremes, the indicator indicators, on the contrary, will decrease, forming new minimums.
In the picture above, I have shown a divergence signal. Here we see how the chart with the price for the Euro / USDollar pair continues to grow, while the indicator moves in a completely opposite direction - it falls. After some time, the price chart also turns into a downward movement. The MACD histogram gives a serious signal to doubt the current trend when it breaks the zero line with a downward fall. It is obvious that the price of the pair has reached its peak at the current moment and after some time the trend has changed to bearish. The histogram warned of a trend reversal in advance.
Let's define divergence signals
The emergence of divergence can be signaled by certain market conditions and specific price behavior. Correct analysis of the chart helps to anticipate the possible emergence of divergence with a subsequent trend change.
- First, we determine the current trend, as shown in the picture - it is upward.
- Depending on the direction of price movement, we define the minimums or maximums. In our case, these are the maximums.
- Further, on the chart, we select 2 maximums (or 3 as it turned out in the picture), at the top points of which we draw a trend line, it gives a signal about the origin of divergence.
- Then the indicator is superimposed on the chart. The most suitable for identifying divergence is the MACD histogram, which I used in our example.
- We also connect the maximum points of the histogram with a trend line. We try to make them coincide in time with the marked lines on the price chart.
- After drawing the lines, it is obvious that a price divergence has occurred, which indicates a possible reversal. It is necessary to determine the point of entry into the market. The best option for opening a deal at the first formed candlestick, which was lower than the previous one. A divergence formed on it.
- The exit from the trade is at the level where the first candlestick formed, which closed with a price higher than the previous candlestick. This signals a possible slowdown and trend change.
- Stop-loss is set slightly above the high of the price at which the divergence signal appeared.
Features of working with an oscillator signal
When determining a possible divergence or convergence, it is imperative to use an indicator. The most popular for identifying divergence among traders are: RSI, MACD histogram or stochastic. The most recommended for work is the histogram.
- For a simpler perception, the histogram is made in two colors, green and red, where the first color indicates growth, and the second option is a price reduction. In the picture above, I have used the AO indicator. It showed an entry point after the formation of a low, a pullback in price and the next formation of a low. Which coincided with a new high on the price chart, followed by a trend reversal on the next candlestick.
- The strongest signal for a reversal after the formation of a divergence is considered when the histogram has formed not one top, but two. The price formed one maximum, rolled back a little, then a second maximum appeared. This phenomenon is called divergence accumulation. I will write about him a little later.
- The more the slope or divergence of the graphs is formed, the stronger the potential for working out the divergence becomes.
Divergence accumulation peculiarity and significance
Every practicing trader has faced the cumulative feature of the signal. The problem is that when such a situation arises, it is not always clear what to do right.
When analyzing the chart of the MACD histogram, a situation often arises in which local extremes are formed on the indicator chart, while each next one does not cross the zero line. Then not two peaks can form, but as many as three. Many traders close the position in such a situation.
However, upon further analysis of the chart, we will see that the divergence signal was not canceled, but worked out in a different market situation. Obviously, the signal was building up potential.
This happens for the reason that the divergence is estimated not over the entire chart, but over the local part. And in this part, there is a trend reversal within a more global movement. In other words, there is a correction in relation to the general schedule. After the correction, when the main trend continues, the indicator, confirming the main direction, forms a new maximum (without crossing the 0 line) and moves along with the main trend. Now they become one strong signal. The movement continues until the trend changes.
Divergence appears when there is a previous strong trend; it is useless to look for a signal in the sideways movement of the price chart. Indicator signals, which are used to determine divergence, increase with increasing volume in the market. The latter are growing as a result of the infusion of big money by professionals or large players with the main goal of changing the current trend. An additional factor that changes the direction of the trend is the release of important economic or political news.
Situations where divergence and convergence forex can give false signals
Throughout the history of the formation and development of technical analysis, traders have analyzed and displayed a large number of signals, graphical figures, patterns, the appearance of which on the price chart signals a possible trend reversal or the onset of sideways movement. Not a single signal gives us a 100% guarantee of working off. Divergence also has features that should be taken into account when a signal appears on charts:
- Often the emergence of divergence, which is then not worked out, is associated with the desire of the market to take a break. This occurs on the eve of the release of important political or economic news. Therefore, experts advise using a signal only during periods of absence of strong negative or positive events in the market.
- Analysts note that divergence is pointless on small timeframes - 5-minute or 15-minute. The older the timeframe on which the signal originated, the stronger the potential for working out. What are the H1, H4 and higher charts used for.
- It is better to analyze divergence using additional methods, look at the general market situation, volumes, and use additional methods of technical analysis. For example, use reversal chart patterns - head and shoulders or double or triple bottom. Additionally, analyze the candlestick chart to identify candlestick combinations of reversal or trend continuation.
Varieties of divergence and convergence
Depending on what continuation the signal will have on the chart, the conditional divergence is divided into three types:
- Classic divergence. It is a signal for a possible trend reversal and, depending on the type of direction of movement of the charts (convergence or divergence), it helps to open a short sell position or a buy trade of an antik. Highs on the price chart and indicator are formed in opposite directions.
- Hidden. When it is formed, each higher maximum of the price chart corresponds to the minimum of the indicator. And vice versa. Such divergence signals the continuation of the current trend.
- Weak. With such a divergence, the maximum points of the price chart are located approximately at the same level, and the extreme points do not appear on the indicator.
Conclusion. Divergence signals as a strong tool for entering the market
Divergence signals are recognized by traders all over the world. A lot of literature is devoted to the study of the issue. Try analyze divergence patterns on the chart yourself to gain the necessary experience to trade and earn on signals. Determine for yourself an understandable and convenient indicator for analyzing divergence.
The main advantages of divergence models:
- can be used on any timeframe, confirming the received signal by the presence of divergence on a higher time interval;
- you can trade using divergence signals both in the direction of the trend and against the main price movement;
- regardless of which pattern is formed - hidden, classical or weak, they show a strong signal.
It is important to remember that like any other signal or technical analysis model, Forex divergence and convergence is not an accurate reversal pattern. In specific market conditions - a small timeframe or the release of important economic events, signals can become false. Experienced traders are advised to use auxiliary tools for a thorough analysis of the resulting divergence signal. This will help to identify possible false signs and minimize the closing of a position by stop loss.