Divergence is a popular trading strategy used by many forex traders. It is based on the idea that when the price of a currency pair diverges from a technical indicator, it signals a potential change in trend direction. In other words, divergence occurs when the price of a currency pair moves in a different direction than the technical indicator. A strong divergence trade occurs when the price and technical indicator continue to diverge for an extended period. So, how can traders tell if a divergence trade is going to be strong?
Understanding Divergence
Before we dive into identifying a strong divergence trade, it is essential to understand what divergence is and how it works. There are two types of divergence: regular and hidden. Regular divergence occurs when the price of a currency pair makes a higher high, but the technical indicator makes a lower high. This situation suggests that the upward trend is weakening and could be reversing. On the other hand, hidden divergence occurs when the price of a currency pair makes a lower low, but the technical indicator makes a higher low. This situation suggests that the downward trend is weakening and could be reversing.
Identifying a Strong Divergence Trade
To identify a strong divergence trade, traders must look for several key factors. Here are some of the most important ones:
1. Multiple Divergences
A strong divergence trade occurs when there are multiple instances of divergence between the price and the technical indicator over an extended period. This situation suggests that the trend is weakening and that a reversal is likely. Traders should look for at least two or three instances of divergence before entering a trade.
2. Confirmation
Confirmation is essential when trading divergence. Traders must look for confirmation from other technical indicators or chart patterns to confirm the potential reversal. For example, if there is a regular divergence between the price and the RSI indicator, traders should look for a bearish candlestick pattern to confirm the reversal.
3. Timeframe
The timeframe is also critical when trading divergence. Traders should look for divergence on higher timeframes, as they are more reliable and tend to produce stronger trade signals. For example, if there is a regular divergence on the daily timeframe, traders should look for confirmation on the four-hour or one-hour timeframe before entering the trade.
4. Market Environment
The market environment is also an essential factor to consider when trading divergence. Traders should look for divergence in a trending market, as opposed to a range-bound market. In a trending market, the divergence signals a potential reversal of the trend, while in a range-bound market, it may not be as reliable.
5. Risk Management
As with any trading strategy, risk management is crucial when trading divergence. Traders should always have a stop loss order in place to limit their losses if the trade goes against them. It is also essential to have a target profit level in mind and to stick to it.
Conclusion
In conclusion, trading divergence can be a profitable strategy when executed correctly. Traders must look for multiple instances of divergence, confirmation from other technical indicators or chart patterns, consider the timeframe and market environment, and have a solid risk management plan in place. By following these guidelines, traders can identify strong divergence trades and potentially profit from them.
