This article is devoted to such a well-known instrument of tech analysis as divergence. Regardless of being so popular and mostly positive traders’ feedback, quite a lot of people had problems with this instrument. I guess, traders have trouble with this instrument when they try to use it for catching reversals in the futures, stock markets, or Forex. However, it is quite an ordeal to try and catch a reversal by any type of tech analysis. That is why I will not touch upon this slippery subject and focus on trading by the trend.
Indicator to find divergence by trend
I opened an H1 chart of AUD/USD, installed the two most popular indicators for finding divergences – MACD and Stochastic – on it, and started comparing their efficacy in the same market situations. Frankly speaking, Stochastic is in no way inferior to MACD in finding divergences by the trend; on the contrary, MACD sometimes loses the game against the faster Stochastic. Hence, for finding divergences by an uptrend or a downtrend, I will be using the latter indicator.
I left Stochastic with its standard settings to avoid confusion – why on earth does one change something that works perfectly? As long as the indicator draws two lines, I will mention at once that I draw the divergence through the most prominent bottoms and tops regardless of the line that creates them.
Signal to buy that divergence by the trend gives
If in an uptrend a divergence by the trend appears, the signal to buy will consist of the following events:
- out of the two local lows necessary for drawing a divergence on the price chart, the second one has formed;
- out of the two local lows necessary for drawing a divergence on the Stochastic chart, the second one has formed;
- the lines drawn through the mentioned lows on the price and Stochastic charts, converge at their right ends.
Judging by the divergences that I had found on the Aussie chart before I wrote this article, there is no reason for hoping for a better entry price than the one that appeared at the moment of the signal to buy by the trend. Sometimes the price pulls back a little during a candlestick or two, as a rule no deeper than the point of the first low forming the divergence. Hence, you should either enter by the market price right after the trend signal appears or by a pending order minimally distanced from the current instrument price.
By the way, it is vital that the second extreme made a false breakaway of the first one. If the breakaway is real, it becomes less probable that the bullish signal will work. Examples of a signal to buy:
As you can see, only the second entry signal by the trend to the left could stay idle, yet a position by it could be taken to the breakeven multiple times, so it is also considered a positive signal.
Signal to sell that divergence by the trend gives
If in a downtrend a divergence by the trend appears, the signal to sell will consist of the following events:
- out of the two local highs necessary for drawing a divergence on the price chart, the second one has formed;
- out of the two local highs necessary for drawing a divergence on the Stochastic chart, the second one has formed;
- the lines drawn through the mentioned highs on the price and Stochastic charts, converge at their left ends.
At this fragment of the chart, out of all the divergences by the bearish trend, only the last one gave a 100% losing signal. But if you recall that I have advised you to use only those trend divergences that have a false breakaway of the first extreme by the first one, you will not have this only losing signal in your trade log because in just this case the second breakaway actually broke through the first one.
Stop Loss and Take Profit
In this strategy, the Stop Loss is placed above the highest high in a divergence by a bearish trend and under the lowest low in a divergence by a bullish trend. You can transfer it towards the profit after new extremes appear. Also, trading either a divergence by a bearish or bullish trend, you should take the SL to the breakeven using each suitable extreme; after the position is protected, try to use only those extremes that the market seems to never test again. As a rule, an extreme is more reliable if it takes time to form.
Place your Take Profit where your experience finds it appropriate, in accordance with the market situation. If you see that the trend is nearly over or that the market is stuck with a level that it fails to break through, this might be the moment to place a TP.
Trading by this strategy, do not risk more than 1% of your deposit during the first month. Take your time to learn how to find reliable and promising divergences by a bearish or bullish trend and feel how the price behaves after a signal appears. When you feel more or less confident, you can increase your risk to 2% but not more than that.
To sum up, I would like to remind you how important it is to trade on the timeframe that suits you, not the one I give you examples on or your friend uses. Also, you will need a lot of patience trading in Forex, the stocks, or futures market. We all know that 70% of the time the market lingers in ambiguous movements and ranges, while our strategy of trading a divergence by the trend requires a bearish or bullish trend that appears for 30% of the time only.
By Dmitriy Gurkovskiy, Chief Analyst at RoboForex