Using Divergence in Trading Strategies
Trading in financial markets involves a myriad of strategies and techniques, one of which is the use of divergence. Divergence is a concept in technical analysis that is used to identify potential market reversals, which can be a powerful tool for traders. This article will delve into how divergence can be used in trading strategies, the types of divergence, and how to identify them.
Understanding Divergence
Divergence occurs when the price of an asset and a related indicator move in opposite directions. This discrepancy can signal a potential reversal in the price trend. In trading, divergence is commonly used in conjunction with momentum indicators such as the Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), or Stochastic Oscillator.
Types of Divergence
There are two main types of divergence: regular and hidden. Each type of divergence can further be categorized as either bullish or bearish.
Regular Divergence
Regular divergence is used to signal potential price reversals. A bullish regular divergence occurs when the price forms lower lows while the indicator forms higher lows. This could signal a potential upward reversal. Conversely, a bearish regular divergence occurs when the price forms higher highs while the indicator forms lower highs, signaling a potential downward reversal.
Hidden Divergence
Hidden divergence, on the other hand, is used to suggest continuation of the current trend. A bullish hidden divergence occurs when the price forms higher lows while the indicator forms lower lows. This suggests that the upward trend may continue. Conversely, a bearish hidden divergence occurs when the price forms lower highs while the indicator forms higher highs, suggesting that the downward trend may continue.
Identifying Divergence
To identify divergence, traders typically use momentum indicators in conjunction with price action. The process involves looking for discrepancies between the direction of the price and the direction of the indicator. Here are the steps to identify divergence:
Step 1: Choose an Indicator
Firstly, select a momentum indicator that you are comfortable with. Common choices include the RSI, MACD, or Stochastic Oscillator. The choice of indicator can depend on your trading style and the specific market you are trading in.
Step 2: Identify Peaks and Troughs
Next, identify the peaks and troughs in both the price and the indicator. This involves looking for the highest and lowest points in a given time period.
Step 3: Look for Discrepancies
Finally, look for discrepancies between the direction of the price and the direction of the indicator. If the price is making higher highs while the indicator is making lower highs, this could signal a bearish regular divergence. Conversely, if the price is making lower lows while the indicator is making higher lows, this could signal a bullish regular divergence.
Conclusion
Divergence can be a powerful tool in a trader’s arsenal, potentially signaling market reversals or trend continuations. However, like all trading strategies, it is not foolproof and should be used in conjunction with other technical analysis tools and fundamental analysis to increase the chances of success.
