In the world of trading, there is fundamental and technical analysis used by traders to assist in making decisions. While fundamental analysis focuses on news and market sentiment, in technical analysis a trader mostly uses a number of indicators to find out what might happen to future price movements. The trading indicators are used to offer a simple method of recognizing patterns and making it easier to predict which direction the price will move.
Among the many trading methods used, there is the divergence method which is one method that can provide a favorite trading signal among traders.
What is Divergence?
Divergence or divergence is an early sign of a market change that indicates when the market is losing its strength. Where when the market is moving in one direction, the real market forces are preparing to reverse direction or reversal.
Prices should move in the same direction and by the same amount on charts and indicators. If the price rises above the preceding candle, the indicator should also rise.
In other words, when this signal appears, a trader can determine if a trend will continue in the same direction or slow down and possibly reverse direction.
What is Divergence in Trading?
Basically, divergence trading is a trading method that uses a benchmark for the difference between price movements and oscillator indicator movements. Oscillator indicators that can be used such as MACD indicators, RSI indicators, Stochastic indicators, and similar indicators.
Divergence is often used to spot changes in the way prices are moving in a trend. Even though it seems simple, many traders have trouble understanding divergence. Even if you are just starting out, you should learn the basics of trading.
Divergence means that the current trend is losing speed and could soon turn around. Some investors use divergence to figure out if a trend will keep going or not. There are two kinds of divergence on the foreign exchange market: regular and hidden.
How to Trade Divergence?
As explained earlier, there are 2 types of divergence that are generally known, namely regular divergence and hidden divergence. To start trading divergence steps in Forex trading, we have to understand technical analysis to make it easier to understand the steps in practicing divergence in Forex trading. To be clear about the 2 types of divergence, consider the following explanation:
Regular (classic) divergence
Classic or regular divergences are signs that indicate that a price trend reversal will occur. Regular divergence itself is further divided into two, namely regular bullish divergence and regular bearish divergence. Find out how to trade a classic divergence in detail.
When the indicator is in a higher low position and the price on the chart is in a lower low position, bullish divergence frequently happens. These signs indicate indication of a trend reversal or reversal, namely a reversal from a downtrend to an uptrend (bullish).
Regular Bearish Divergence occurs when the price on the chart is in a higher high position, while the indicators are in a lower high position. These signs indicate indication of a trend reversal or reversal, namely from an uptrend to a downtrend (bearish).
If there are hidden divergences, it means the trend will continue. A concealed divergence can take the form of either a concealed bullish divergence or a concealed bearish divergence.
Bullish divergence is concealed when the indicator is at a lower low and the price is at a higher low on the chart. All things considered, it appears the recent upward trend may continue.
When the price is at a lower high on the chart but the indicators are at a higher high, hidden bearish divergence is present. These indicators suggest that the current bearish trend may persist.
What is MACD indicator?
The MACD (Moving Average Convergence Divergence) indicator is a very simple and easy-to-use trading indicator because it is very useful for a trader. The MACD indicator is an indicator that is useful for detecting overbought and oversold conditions by looking at the relationship between 2 moving average indicators for the long term and short term.
According to Thomas Aspray in 1986, the difference between MACD and the signal line is often calculated and expressed not in the form of a line, but in the form of a histogram bar graph.
MACD itself has 3 parts, consisting of 2 lines, and 1 histogram. Where the three parts are:
- Signal Lines. Usually red. Calculated from the EMA (Exponential Moving Average) indicator in a span of 9 days. And the period of the Signal Line can be changed.
- MACD Line. This line is calculated from the reduction of the 26-day and 12-day EMA (12-EMA – 26 EMA). The period can be changed according to preference
- MACD Histogram. This MACD histogram bar graph is calculated by subtracting the MACD Line value from the Signal Line (MACD Line – Signal Line).
From the description above, the MACD is written as MACD (12,26,9). The standard period suggested by Gerald Appel in the 1960s was to use a period of 12 and 26 days.
The way to read the MACD divergence indicator, in this case, is not much different from the divergence strategy in general. When the price tends to go up (forming a higher high) but the MACD area actually decreases (creating a lower high formation), the uptrend will soon reverse down. This is because rising prices are not supported by strengthening momentum.
On the other hand, when a downtrend is in a downtrend, it can reverse upwards if the MACD area in the negative zone actually increases (forming a higher low). This condition indicates that although sellers are still in power, the bullish momentum continues to strengthen. In the end, the price downtrend will turn into an uptrend when the MACD area actually crosses into the positive zone
There are also functions and uses of the MACD indicator, including:
- Identify price trends
- Knowing trend reversals, and detecting momentum
- Identify overbought and oversold
What is the RSI indicator?
The RSI (Relative Strength Index) indicator is a type of technical indicator that looks at how much prices have changed over a certain time period to figure out if the market is oversold or overbought (overbought). The RSI indicator is mostly used to find out when an investment asset is oversold or overbought, but it can also be used to spot new trading opportunities. RSI is a type of technical indicator known as an oscillator (precedes price movements).
In general, the RSI is used like other indicators to look for buy and sell signals. When the RSI goes into the overbought area, it’s a sign to sell. When the RSI goes into the oversold area, it’s a sign to buy.
When the RSI goes from overbought to below 70, it confirms a sell signal. When the RSI goes up from the oversold area and is above 30, this is a sign that you should buy.
RSI can also be used to show when prices are diverging from each other. Divergence happens when the RSI line doesn’t move “in line” with price changes in the market. If the price tends to go up but the RSI line tends to go down, it will be bearish in the future.
On the other hand, if the price tends to go down but the RSI line doesn’t go down, as in the example above, it will go up (be bullish) in the future.
Don’t worry if you want to learn more about how to use divergence or if you didn’t understand what was said about it this time. Analysts at FBS are ready to give the best advice and education they can. You can talk to our analysts about anything related to investing or trading if you join FBS’s large family of Forex brokers who are known for providing good service around the world.
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