How To Predict The Future: The Power Of Divergence

Hello there traders!

Today’s educational article is going to rock! :-) This is not a tool you want to miss out on. Today we will be discussing the “magic” of convergence and divergence in trading.

Last week we discussed in detail the advantages of using the Awesome Oscillator for and in your trading.  We explained how you can use the tool in detail. One of the advantages of the indicator is its usage in determining divergence and convergence (point 3 of that article). However, considering the importance of divergence and convergence, the topic deserves to be expanded into a full scale article.

Before we dive into the reason why divergence and convergence is a vital tool, let us first explain what it means.

What is divergence and convergence?

The definition of converge is to come together, for example the lines converge at this point. To diverge means to move or draw apart. When a currency pair is converging, it means that price and momentum are in sync with each other and price is moving at a sustainable pace. When a currency pair is diverging, it means that price and momentum are NOT in sync with each other and action is moving in a less stable/sustainable pace and the likelihood of a correction or even reversal increases. The divergence-convergence analysis basically measures the power a currency has at one point in time with another point in time and then compares the two with each other. The analyst can then judge whether the currency is showing signs of strength or weakness.

Why is it important?

The convergence and divergence tool is a very powerful method. The main benefit from this analysis comes from the fact that it is not lagging. Similar to price action, the convergence and divergence analysis is very useful support in predicting future price behavior based on current values. This is the opposite of lagging indicators which by definition are always following price action in their development.

Price action of course always gives the most up to date information, but interpretation of price is an art and not an easy task. Adding a method to support one’s strategy and an analysis which has more predictive value could be very useful.

How do divergence and convergence like look on a chart?

At its core divergence trading has one key and vital rule. If price makes a higher high, the oscillator should also be making a higher high. If price makes a lower low, the oscillator should also be making a lower low. This statement could be printed out and taped above your pc if you like. In cases this does not happen, something “fishy” is happening and the analyst may look for more clues to determine the currency pair’s behavior and diagnosis.

Divergence-convergence can only be evaluated when price has either formed:

  • A higher high than the previous high
  • A lower low than the previous low
  • Double top
  • Double bottom

The MACD and Awesome Oscillator (AO) are the best indicators to measure such a move. The RSI, the relative strength index, is another method. I myself prefer using the AO.

A proper divergence is only present when the histograms indicating momentum have retraced back to the zero line. Two subsequent lows or highs where the histograms have not returned to the zero line are not proper divergences. These are sometimes called bad divergences. Often enough if a trader would zoom in 1 time frame a proper divergence would become noticeable there.

25.01.2013 EURUSD day divergence

How to use regular divergence – convergence

A regular divergence is used as a possible sign for a trend pause or trend reversal.

A regular bullish divergence occurs when price is making lower lows (LL), but the oscillator is making higher lows (HL). Usually this happens at the end of a down trend. Price and momentum are expected to move in line with each other. If price makes a new low, but the oscillator fails to make such a new low itself, it is likely that the price will retrace or even reverse.

The opposite is true for regular bearish divergence, which happens when the price is making a higher high (HH), but the oscillator makes a lower high (LH). This type of divergence can be found in an uptrend and when such a divergence occurs price will most likely retrace or reverse.

Divergence and convergence can be used in multiple manners:

-          When the currency is converging, the likelihood of trend continuation is high and trend reversal is unlikely (this guideline is somewhat less reliable on lower time frames)

-          When the currency is diverging, the likelihood of trend continuation is decreasing and trend reversal is possible

-          When the currency has double or triple divergence, the likelihood of  trend continuation is unlikely and a trend reversal is a decent probability

The oscillators indicate to us that momentum is possibly shifting and even though price has made a new peak or bottom, the chances of the momentum being sustained and continued are decreasing. Regular divergence is useful for cautiously predicting the end of a trend but only in some cases will the currency pair totally reverse for a trend in the opposite direction. May I emphasis the word cautious in the previous sentence. It is a tricky trading element to master and it is always beneficial to add other methods of confirming a trend is potentially ending.

Other methods of confirming divergence

One method of analyzing divergence from a different perspective is by using trend lines and trend channels. Once divergence occurs in the market, the single line trend lines can identify when a trend is ending and may signal the end of a trend. Waiting for that break could be one way of trading divergence. Similar trend lines can also be used on the momentum indicators themselves (f.e. using the same spots in time as on price action). The momentum trend lines will be useful in identifying and spotting reversals and trend breaks.

Another important point is by managing expectations with regard to divergence. There is a substantial different between the pip size of a reversal and a retracement. Be careful to reckon and plan on both in your trading plan. One way of distinguishing between the two is by looking at the time frame. If a trader is observing a 15 min or 1 hour divergence, the divergence will most likely create a pause or retrace within a bigger trend continuation. If a higher time frame has divergence, the likelihood of a trend reversal is higher. Basically the higher the time frame, the more powerful as you can see in this example of the EURUSD. Also, the likelihood of a trend reversal increases if double or even triple divergence is spotted. In Elliott Waves term this is explained by the divergence between Wave 3 and 5 of a bigger Wave 3 and then the divergence between bigger Wave 3 and 5.

A trader can also decrease the risk of divergence trading by only trading divergences when they occur on multiple time frames. The likelihood of a bounce increases when more time frames show diverging movements between price and momentum.

How to use hidden divergence

While regular divergence is especially useful for cautiously predicting the end of a trend, hidden divergence can be a good indication of trend continuation. Hidden bullish divergence takes place when price is making a higher low (HL), but the oscillator is showing a lower low (LL). In an uptrend hidden divergence happens when price makes a higher low but the oscillator makes lower low.

Hidden bearish divergence occurs when price makes a lower high (LH), but the oscillator is making a higher high (HH). In a downtrend hidden divergence happens when price makes a lower high but the oscillator makes higher high.

25.01.2013 EURJPY hidden bullish divergence

Last comments

Please be careful when implementing this method in your strategies and make sure to do proper back testing and incorporate other tools and time frames to confirm the divergence and convergence readings.

Before I wish you a good weekend, I am giving you a must read article from Casey on Forex Inspirational Tips For Life - enjoy! Have a great Friday, weekend and Good Trading!

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Chris is the head of the mentoring program and trading room at Winner's Edge Trading. He has a passion for technical analysis and helping Forex traders achieve their goals in trading. Chris has been trading for almost 10 years and is most fond of the Double Trend Trap (as a strategy), moving averages (as an indicator) and Fibonacci (as a tool).
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