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Forex Divergence – What It Is And How To Use It To Your Advantage

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Forex divergence is the discrepancy that comes between two different data sources. So, if you see a mismatch in the price peaks compared to the indicator peaks, this is a divergence in forex.

In this article, we’ll tell you everything you need to know about divergences in forex, including what causes trade divergences and how you can use them to your advantage when you’re trading forex.

What Is A Divergence In Forex?

A divergence in forex occurs when the price action and an indicator move in two different directions. For example, if the price peak is higher than the indicator peak.

Picture yourself driving a car. You see that your speedometer is quickly climbing, but when you look at the road, you’re not actually speeding up. This is divergence – a difference in what your instrumentation is saying and how you perceive the environment.

Trade divergences are most commonly found on the oscillating indicators, such as RSI, CCI, MACD and Stochastic. However, you may also see divergence on the volume indicators.

What Does Divergence In Trading Mean?

When you see divergence in the graphs, this means that a price reversal is likely to happen soon, or that the current impulse has been resolved.

It’s important to note that divergence should never be used as a signal on its own. Instead, you should look for the main signal, only using the divergence pattern as confirmation that the market is heading in the way you expect.

So, you should never work purely on the principle of divergence trading – instead, use divergence as a tool to inform your trading decisions.

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Types Of Divergence

There are many different types of divergence in forex that you need to be aware of. These include:

  • Regular divergence
  • Extended divergence
  • Hidden divergence

Each of these types of divergence can also be divided into bullish and bearish divergence.

Let’s take a look at each of these in more detail.

Regular Divergence

Regular divergence is the most commonly found type of divergence. It occurs when the price trend makes a higher high or lower low, while the indicator forms a lower high or higher low.

In other words, the price and indicator are heading in different directions.

Regular bearish divergence occurs when the price chart shows a higher high whilst the indicator chart shows a lower high. This usually means that we’re about to see a downward price movement.

In contrast, in regular bullish divergence occurs when the price chart shows show a lower price value whilst the indicator charts shows a higher low. This usually means that we’re about to see an upward movement.

You can use regular divergences to predict both corrections and reversals.

 

Extended Divergence

Extended divergence is a type of divergence that’s seen less frequently than regular divergence. It happens when the price chart forms a double top or a double bottom, whilst the indicator chart shows the second peak as being lower.

In an extended bearish divergence, the price will make a new high, while the indicator will make a lower high. This is an indication that the market is losing steam and may soon start to head downwards.

In an extended bullish divergence, the price will make a new low, while the indicator will make a higher low. This suggests that the market has found support and may soon start to move upwards.


Hidden Divergence

Hidden divergence is a type of divergence that can be difficult to spot. It happens when the price trend makes a higher low or lower high, while the indicator forms a higher low or lower high.

In other words, both the price and indicator are heading in the same direction but at different rates.

In a hidden bearish divergence, the price will make a higher low whilst the indicator will make a lower low. This suggests that the market is losing momentum and may soon start to head downwards.

In a hidden bullish divergence, the price will make a lower high whilst the indicator will make a higher high. This suggests that the market is gaining momentum and may soon start to move upwards.


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How To Trade Divergence

Now that you know what divergence is and the different types that you may come across, it’s time to learn how to trade it.

When trading divergence, you should always remember that it’s a leading indicator. This means that it can give you an indication of where the financial markets are heading, but it’s not always 100% accurate.

As such, you should never trade divergence on its own. Instead, use it as a tool to confirm your other trading signals through your technical analysis.

For example, if you see a regular bearish divergence on the EUR/USD chart, you might want to consider opening a short position. However, you shouldn’t do this until you see a bearish candlestick pattern or another type of bearish signal.

The same goes for bullish divergence. If you see a regular bullish divergence on the EUR/USD chart, you might want to consider opening a long position. But, as before, you shouldn’t do this until you see a bullish candlestick pattern or another type of bullish signal in the currency pair.

how to trade divergence

Watch Out For False Signals

When trading divergence, you should also be aware of false signals. This is when the market gives you a signal that suggests one thing but then does the opposite.

For example, you might see a regular bearish divergence on the EUR/USD chart and decide to open a short position. But then, instead of the market falling, it starts to rise. In this case, you would have been better off not trading the divergence signal.

To avoid false signals, you should always wait for the candlestick pattern or other signal to confirm the divergence before entering a trade.

You should also be aware that divergence can last for a long time before the market finally starts to move. As such, you need to be patient when trading divergence and be prepared to hold your positions for a while.

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Don’t Forget Stop-Loss In Your Forex Divergence Strategy

Lastly, when trading divergence, you should always use stop-loss and take-profit orders. This will help you to protect your profits and limit your losses if the market moves against you.

When trading divergence, you should always use stop-loss and take-profit orders. This will help you to protect your profits and limit your losses if the market moves against you.

Stop-loss orders are placed below the entry price for long positions and above the entry price for short positions. Take-profit orders are placed at a level where you think the market is likely to reverse.

For example, let’s say you see a regular bearish divergence on the EUR/USD chart and decide to open a short position. You might place your stop-loss order above the recent high and your take-profit order below the previous low.

Final Thoughts

In this article, we’ve looked at what divergence is and how you can use it to your advantage when trading forex.

Remember, divergence is a leading technical indicator, which means it can give you an indication of where the market is heading. However, it’s not always 100% accurate.

As such, you should never rely on divergence trading on its own. Instead, use it as a tool to confirm your other trading signals through technical analysis.

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